• The Lump of Labour Fallacy

    Popular wisdom and what passes for common sense are not always the best guides to running a successful economy. That is why businessmen who have a good practical grasp of what it takes to run a successful business are often wide of the mark when it comes to making policy for a whole economy.

    An economy, contrary to what is often asserted, is not like a business. Particularly in down times, the measures that might be required in the interests of an individual business are the very reverse of what is needed by the economy as a whole. Cutting costs, deferring investment, and laying off workers will help to balance a single set of business accounts but are the last thing that a whole economy needs if it is to avoid continued recession.

    It is often the case that good economic management may seem counter-intuitive. A case in point is what economists call the ‘lump of labour” fallacy – the belief that there is a fixed amount of work available and that the task is to decide how that is to be shared out fairly.

    The fallacy is alive and well in the minds of even experienced policy-makers. We saw shades of it in the “nine-day fortnight” that emerged as a counter-recessionary strategy from last year’s job summit. The idea, which not surprisingly had little impact in practice, was based on the notion that if a fixed amount of work could be shared out, more jobs would be created, or at least saved. By diverting attention from what was really required – a policy which would increase the number of jobs – it actually hindered the fight against unemployment.

    The fallacy rears its head unhelpfully in other contexts as well. In the perennial debate in developed countries about immigration, one of the main arguments advanced against allowing an inflow of newcomers is that they will “take our jobs”. There is little recognition of the real possibility that a controlled rate of immigration could create jobs and expand the economy.

    There are of course many considerations in determining what are appropriate levels and kinds of immigration; but we would no doubt reach better decisions on matters such as this if we could free our minds of intuitive fallacies and look at the practical evidence. The great economic success of a Hong Kong, for example, was greatly helped by the constant inflow over many years of (often illegal) immigration from across the Chinese border.

    The “lump of labour” fallacy also underpins an important current debate in our own country. The stubborn refusal of comparatively high unemployment to melt away has again prompted discussion of what the government could or should do to “create” jobs. The very suggestion that something could be done has, however, been greeted – even by very experienced commentators – with the apparently incontrovertible objection that “the jobs just aren’t there.” And that means, it is said, that there is nothing the government can do.

    If that were really the case, of course, the government’s push to get people off benefits and into jobs would be futile. The jobs cannot both be non-existent for the purpose of getting unemployment down, yet waiting there for lazy beneficiaries to take up. And while it is certainly true that there are strict limits as to how far (if at all) governments should try to create jobs by putting in place “make work” schemes, that is not the real issue.

    The reality is that the number of jobs in an economy is not a given, but is a function of the level of demand and therefore of economic activity. The number of jobs falls in a recession and rises in better times. If we want to recover from recession, we need policies that will stimulate demand and purchasing power so that people will buy what producers make, and retailers can boost sales, and employers can see that it is worthwhile to take on more staff, and more people earning good wages will keep the virtuous circle going – so that the government’s finances benefit as well through a higher tax take.

    There is no mystery about this. And the level of demand is very largely determined by policy. A government that provides stimulus to the economy through maintaining or increasing its own levels of spending and investment, as the Australians did, can achieve a great deal in avoiding recession and fighting unemployment.

    If the policy priority, however, is to get the government’s (perfectly manageable) deficit down, the outcomes are equally clear. We may comply with good business practice by pleasing our bankers in the short term, but our economy will be smaller, unemployment will be higher and the recession longer. If we really want to please our bankers in the longer term, we should be growing the proportion of our resources devoted to production and exports. That will not be achieved by allowing a prolonged recession to close down parts of our productive capacity.

    Bryan Gould

    15 August 2010

    This article was published in the NZ Herald on 31 August.

  • Needless Casualties in the Economic War

    On Anzac Day, we remembered the sacrifice made by thousands of young New Zealanders at Gallipoli – sent to their fate because those with the power to make decisions had neither the wit nor the courage to depart from a course that everyone knew was doomed to disaster.

    A day after Anzac Day, we learned of another kind of sacrifice – of 350 jobs at one of New Zealand’s most iconic enterprises. This time, there was the same inevitability about the outcome of a strategy that everyone knew was failing but there were no incompetent and far-away British decision-makers to blame. This time, we were doing it to ourselves.

    The Fisher and Paykel decision, after all, did not come out of the blue. We have been sleep-walking towards it for a very long time. Nor is it an isolated instance of policy failure. Behind this decision stand many other Fisher and Paykels, all facing the same imperatives, the same inevitability, the same disastrous consequences of a discredited orthodoxy that no one in power has the courage to challenge.

    In theory, the current orthodoxy could not be simpler. Inflation is to be controlled by manipulating the price and therefore the supply of money, a task entrusted to technicians who are immune to political pressure. With the threat of inflation painlessly removed, the economy is free to flourish and investors can make their decisions with confidence.

    We have now had a protracted opportunity to test this attractive theory in practice. We now know that, while increasingly ineffective and possibly even counter-productive as a counter-inflationary strategy, the orthodoxy is profoundly destructive of the high-productivity, export-oriented economy that our business and political leaders say they want.

    Fisher and Paykel’s catastrophic loss of competitiveness as a New Zealand manufacturer represents just the first-order consequences of the high interest rate, high exchange rate regime that monetarist policy makes inevitable. Faced with an over-valued currency, all New Zealand enterprises that seek to do business in the internationally traded goods sector (including our own home market) face an unattractive choice; either they lose market share through declining competitiveness or they try to maintain price competitiveness by shaving margins and risk having to trade at a loss. For most, the outcome will be an even less attractive combination of both.

    The medium-term impact is severely damaging to our economy. New Zealand companies struggling to maintain competitiveness find that shrinking markets and disappearing profits mean that they do not have the money to catch up on foreign competitors by re-investing in new technology or upskilling staff or conducting leading-edge research or mounting an effective sales campaign or offering improved after-sales service. The result? They fall behind in the productivity race, forced to lose yet more market share at home and to give up the attempt to export. If they do survive, they move offshore or are bought up by foreign competitors.

    In the longer-term still, the consequences of an over-valued currency begin to shape our culture. The only people who make money are the speculators, who manipulate existing assets and create no new wealth. The best brains and best resources gravitate to the non-traded sector and we give up the attempt to move them to the traded sector where the real prospects for growth lie. We become risk-averse, preferring to invest in domestic assets, like housing, rather than chance investment in a high-risk productive enterprise where the threat of failure is ever-present.

    In vain do our leaders berate us for our obsession with housing, our predilection for artificially cheap imports, our unwillingness to save. In vain are we urged to improve productivity, to spend less and to save more. Economics is a behavioural science. Like Fisher and Paykel, we each of us make the decisions made inevitable by the policies adopted by our leaders.

    We are now being driven towards what everyone knows is literally a dead end. We have impaled ourselves on the horns of a dilemma of our own making. It is happening in the name of an orthodoxy that cannot deliver even the limited counter-inflationary outcomes that it promises. Ministerial exhortations do nothing but emphasise how far the dream of high productivity has become – by virtue of literally counter-productive policies – an unattainable chimera.

    We cannot escape from this dilemma until we recognise what it is. The more we push up interest rates and the exchange rate, the less competitive we become and the more we fall behind in terms of international competitiveness. The less competitive our real economy, the more entrenched is our inability to pay our way in the world and the more dependent we are on short-term “hot money” to bale us out. The more we need “hot money”, the more we need to push up interest rates and the exchange rate, the more our competitiveness declines still further and the more threatening inflation becomes.

    We must stop relying on interest rates and the exchange rate to perform tasks for which they are not suited. We should instead free our minds of current dogma, restore economic policy to democratic control and ensure that the economy is run in the common interest. That means a more accurate analysis of what is going wrong and what is needed to fix it. It means a better focus – not just on controlling inflation through fiscal measures, more effective controls on the level and purposes of bank lending, and measures to restrain the booming housing market – but on macro-economic measures to improve competitiveness and encourage growth and investment.

    For the moment, however, there is only one question worth asking. How many more needless sacrifices must be made before we say that enough is enough and that a new course must be tried?

    Bryan Gould

    27 April 2007