Vicious and Virtuous cycles – the political economy of unemployment in interwar UK and US

Kent Matthews, Patrick Minford, Ruthira Naraidoo

09 July 2008

a

A

Why is unemployment high in some countries and low in others? Why has the same country experienced high unemployment in some periods of its history and low unemployment in other periods? The economic history of the Western world is one of prolonged bouts of low unemployment and high unemployment. An obvious example is the low unemployment associated with the roaring 20s in the USA followed by the mass unemployment of the Great Depression. Post war continental Europe grew rapidly with full employment in the 1960s ands 1970s but in the 1980s and 90s there was stagnation and relatively high unemployment.

The relationship between economic performance and institutions is an area of considerable debate.

The Political Economy of the Supply Side

Douglas North (1981) charted the way in which protestant dissent in the low-countries and England produced the first industrial revolution. Deepak Lal (1998) has taken this argument further back to show how competition in Europe between nation states under the edicts of Papal Christendom gave capitalism its secure basis.

Mancur Olson (1971, 1982) set out the mechanism by which vested interest groups could prevent the general good by exercising discipline over their members who have strong vested interests at stake. The general public individually do not appreciate how their own interests are prejudiced by the actions of the vested interest groups. Hence politicians find it difficult to mobilise opinion in favour of economic reforms because such action is costly and the rewards uncertain. However, the vested interest groups offer personal and political rewards to politicians that represent them in their ‘rent-seeking’ activity.

Yet in spite of the existence of vested interest groups, supply-side reforms do occur.

Think of the wide-ranging reforms of the Thatcher administration during the 1980s in the UK, and in the US the Carter deregulation of the 1970s and the Reagan tax reforms of the 1980s. On these occasions it proved possible for politicians to build up a core of public support to follow through with economic reforms.

Thus there is a tension between the strength of the vested interest groups and the interests of the general public. Models of voting behaviour have attempted to explain this tension in the context of the political business cycle. It is natural to extend this approach to supply side issues that impinge on the natural rate of unemployment.

A model of vicious and virtuous circles in unemployment

The main hypothesis advanced in this column is that prolonged bouts of high unemployment and low unemployment occur through a process of political economy. We argue that the structure of the economy (particularly the supply side) alters in response to shocks to the economy.

The mechanism by which demand shocks get translated into reinforcing supply-side interventions is through the political process. Shocks that cause sharp cyclical demand swings generate political reactions from public opinion and vested interest groups, which in turn influence the supply-side and therefore the natural rate of unemployment.

In this way, negative demand shocks produce reinforcing distortionary supply-side responses through an increase in the political demand for social protection. These distortions produce an equilibrium with a higher natural rate of unemployment which in turn creates a further rise in the political demand for social protection and so on until an equilibrium is reached where the bad effects are so bad that there is no further additional demand for social protection.

Similarly, a run of positive demand shocks produces a more liberal supply-side policy as people are less nervous about potential misfortune. This in turn generates a self-reinforcing political process in favour of supply-side reform and the economy moves in a virtuous circle to a low-unemployment high output equilibrium.

Minford and Naraidoo (2004) develop a model based on the Meltzer and Richard (1981) model of redistribution financed by distortionary taxation and political economy of supply-side based on Wright (1986). Policy is set as in the standard median voter model.

The model predicts that the size of the general redistributive programme reflects the preferences of the middle classes (the likely median voter) and is determined by their relative position on the income scale. According to Wright (1986), workers have different unemployment risks, and unemployment benefits play the role of insurance against adverse shocks. The median voter will optimally determine the better insurance benefits against the costs of higher distortionary policies. But the more exposed the median voter is to unemployment the stronger the support for higher unemployment benefits. However as noted by Saint-Paul (1996), in so far as higher unemployment benefits raise wages and destroy jobs, the higher exposure of the median voter to unemployment will increase the demand for protection in terms of higher unemployment benefits but at a diminishing rate.

The model of Minford and Naraidoo (2004) has two components to it – a model of the natural rate of unemployment and a model of the political economy of supply-side policy. The model of the natural rate of unemployment is an extension of the textbook version to include the idea of a permanent unemployment benefit paid without recourse to work availability. The result is to tilt the labour supply curve so that real wages cannot fall below unemployment benefits as in the figure below.

Figure

If the benefit level rises relative to productivity, the natural rate of unemployment increases as the supply of labour schedule shifts up to the left in the figure. Functionally this is modelled as the rate of unemployment being determined by the replacement rate (unemployment benefits relative to wages) and all other factors (including macroeconomic cyclical effects and other supply-side factors such as trade union power).

The second component of the model is the political economy demand for unemployment benefits which is modelled as the replacement rate being determined by a lag in the rate of unemployment and a quadratic lag in unemployment. The quadratic term captures the feature that as unemployment increases the demand for unemployment benefits increases but at a decreasing rate; voters treat unemployment as a noisy signal of the other factors they do not control.

Depending on the parameters of the model, the outcome of the implied non-linear dynamic model is either a single equilibrium rate of unemployment or three equilibria: one low unemployment stable equilibrium rate, one medium unemployment unstable equilibrium rate and one high unemployment stable equilibrium rate.

A series of negative shocks can drive the economy through the self-reinforcing feedback of the political economy process to the high unemployment equilibrium – a vicious circle. Movement out of the high unemployment equilibrium occurs because of a large demand or supply shock that generates a virtuous circle back to the low unemployment rate equilibrium.

The Interwar period

The model has been applied by Matthews, Minford and Naraidoo (2008) to the UK and USA economies of the interwar period. Benjamin and Matthews (1992) have argued that increasing levels and coverage of benefits both in the UK and USA had the effect of raising the natural rate of unemployment and slowed down the natural mechanism of the market.

In the UK, unemployment benefit before first-world-war was initially grounded on the principle of insurance where the worker received a tide-over to deal with temporary maladjustments in the labour market. But the unemployment benefit system that evolved in the interwar period was fundamentally different from this. In 1920 benefits were increased by nearly 40% and the coverage extended to a further 11 million workers. In the following decade political and social forces were active to extend benefits from the principle of insurance to one of maintenance. By 1931, ‘need’ had completely replaced ‘insurance’ as a criterion for benefits. The absolute level of benefits was increased during the period which accompanied with a falling price level had a pronounced effect on the natural rate of unemployment.

In the USA, up until the 1930s unemployment relief was a state government matter. However, the unprecedented rise in unemployment that was the ‘Great Depression’ brought forth a considerable expansion of relief efforts in which the federal government began to play a part. By 1935 a federal system of work relief was instituted based on need. While those who were unable to work or had unsuitable skills received an unconditional cash grant.

The dynamic models for the UK and USA unemployment in the interwar period produced a low unemployment equilibrium of 2% - 3% in the UK and 1% - 2% in the USA, and a high unemployment equilibrium of 16% - 18% in the UK and 20% - 21% in the USA. Benjamin and Matthews (1992) argue that nearly half of the average level of unemployment in the USA during the period 1931-39 could be explained by the effects of federal unemployment policy. The figures for the UK are consistent with the findings of Benjamin and Kochin (1979, 1982).

Policy conclusion

The principal policy conclusion is the necessity of education of the voting public as to the implications of counter-productive social protection in the face of adverse demand shocks.  

References

Benjamin D and Kochin L (1979), ‘Searching for an explanation of unemployment in interwar Britain’, Journal of Political Economy, 87, 441 – 478

Benjamin D and Kochin L (1982), ‘Unemployment and unemployment benefits in twentieth century Britain’, Journal of Political Economy, 90, 410 -436

Benjamin D and Matthews K (1992), US and UK unemployment policies between the wars: a doleful story, Hobart paperback 31, Institute of Economic Affairs, London

Lal D (1998), Unintended consequences – the impact of factor endowments, culture and politics on long-run economic performance, MIT Press: Cambridge Mass

Matthews K, Minford P and Naraidoo K (2008), ‘Vicious and virtuous circles – the political economy of unemployment in interwar UK and USA’, forthcoming, European Journal of Political Economy

Meltzer A and Richard S (1981), ‘A rational theory of the size of government’, Journal of Political Economy 89, 914 – 928

Minford P and Naraidoo K (2004), ‘Vicious and virtuous circles – the political economy of unemployment’, CEPR Discussion Paper 3618

North D C (1981), Structure and change in economic history, MIT Press: Cambridge Mass

Olson M (1971), The logic of collective action: public goods and the theory of groups, Harvard University Press: Cambridge Mass

Olson M (1982), The rise and decline of nations: economic growth, stagflation, and social rigidities, Yale University Press: Cambridge Mass

Saint-Paul G (1996), ‘Exploring the political economy of labour market institutions’, Economic Policy, 22, 263 – 315

Wright R (1986), ‘The redistributive roles of unemployment insurance and the dynamics of voting’, Journal of Public Economics, 31, 377 – 399

a

A

Topics:  Labour markets

Tags:  unemployment, interwar economy

Sir Julian Hodge Professor of Banking and Finance at Cardiff Business School

Professor of Economics at Cardiff University and Director of the Julian Hodge Institute of Applied Macroeconomics

Senior Lecturer, University of Pretoria

Events