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Eric S. Raymond writes,

We've spent the last seventy years increasing the hidden overhead and downside risks associated with hiring a worker -- which meant the minimum revenue-per-employee threshold below which hiring doesn't make sense has crept up and up and up, gradually. This effect was partly masked by credit and asset bubbles, but those have now popped. Increasingly it's not just the classic hard-core unemployables (alcoholics, criminal deviants, crazies) that can't pull enough weight to justify a paycheck; it's the marginal ones, the mediocre, and the mildly dysfunctional.

Actually, health insurance costs could be a huge factor here (and don't tell me that justifies single-payer health care, because that would simply shift the employer's cost from the health benefits line item to the tax line item). Also, I suspect that as work gets more sophisticated, training and orientation costs increase. Garett Jones' organizational capital builders take longer to get up to speed in the company than old-fashioned assembly-line operators.

[UPDATE: Obama Aims to Use Federal Contracts as a Way to Lift Wages - NYTimes, pointer from Mark Thoma]

Whatever the cause, higher labor costs could in theory be offset by lower wage rates. At best, the hypothesis that non-wage labor costs have risen is a partial explanation for high unemployment.

The more I think about it, the less confident I am that we understand the nature of cyclical changes in the level of economic activity. Let me repeat that I find it useful to think of economic activity as outsourcing. If we eat at each other's restaurants, the labor of the chefs will be measured as economic activity. If we eat at home, our cooking labor will not be so counted.

In general, counting non-market labor as economic activity makes sense. Cooking is one of the few examples in which I can substitute for market labor reasonably well. If I had to build my own car or write my own computer operating system, or--to use a classic example--make my own pencil, my productivity in doing that would be effectively zero. Nobody knows how to make a pencil, and yet the market gives us pencils.

The productivity gain from outsourcing rather than doing everything yourself is huge. That justifies counting market labor as economic activity while discounting non-market labor. Incidentally, it also is why buying local on principle is so stupid--it is somewhere in between the intelligence of using the most efficient process and the stupidity of trying to make everything that you consume by yourself from scratch--and probably closer to the latter.

So how does an economy get to a point where there are people who are unemployed--no one is outsourcing any work to them? How can someone who is marginally dysfunctional be employable one month and unemployable next month? Why do so many people wind up unemployed at the same time? Please don't use the comments to reiterate the traditional answers--the Keynesian answer, the Austrian answer, and the monetarist answer. We know what those are. And you all know about the recalculation story. I am open to new answers.

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COMMENTS (21 to date)
Troy Camplin writes:

With the economy the way it is, you don't have to hire marginal workers. You don't have to put up with people showing up late, because they are hard to replace. You don't have to train anybody, because you can find people who already know the job. In fact, I just started a hotel job precisely for those last two reasons. Having done night audit before, I was hired to work night audit at a hotel -- to replace someone who had a hard time showing up on time. So I have a hard time getting a job using my Ph.D. because I am marginal (as humanities scholars who use evolutionary theories, including spontaneous order theory, are), but I can get all the hotel audit jobs I want.

Further, it costs less to hire someone you don't have to train. Especially in an economy where people wonder if they are going to be able to find another job than the one they are being offered. Seems pretty simple to me.

Sonic Charmer writes:

Think of 'employees' as just another sort of 'asset', one that is accumulated by managers in internal competition with each other, in any medium- to larger-sized company. All else equal, managers want and need higher head-counts underneath them to signal that they are bigshots and to climb the corporate ladder.

This can lead to escalation of head-counts, a head-count 'arms race'. So maybe there was a bubble in such 'assets' (employees) just as there was a bubble in real estate. You ask how marginally dysfunctional people could have gone from employable to unemployable in a month. In raw terms, maybe most of those people weren't actually 'employable' in the first place. But those employees had value as head-count in the managerial-class arms race. With the recession, the demand for that sort of expensive signaling has plummeted against other factors, so we've reverted to a state in which the actual cost of employing the marginally-employable becomes the governing factor in whether they are employed. Thus, many of them aren't.

In this light, 'stimulus' approaches look merely like attempts to ramp up the managerial-class arms race again (in practice, this will and probably already has occurred, just in the government sector more than the private sector); in other words, a TARP-like attempt to reinflate that 'bubble'. The 'stimulus' ideas we have seen almost all end up taking the form of cheap government-subsidized loans (of head-count) to MBA's.

A different sort of approach (and, I would think, a profitable one) might begin by contemplating how to make actual economically productive use out of marginally-employable people. Unfortunately, I have seen very little of the latter, from the private sector let alone the government.

Don Lloyd writes:

For most full time employment, the transaction cost losses involved in a full hire/fire cycle are so great that neither workforce expansion nor contraction makes economic sense as a response to modest (say 5%) changes in unit demand.

OTOH, a reduction in unit demand of 30% to 50% cannot be dealt with by any mechanism other than a contraction in labor and production capacity. This has the additional productivity advantage of being able to prune the less productive labor and other factors that have been accumulated over time.

This all means that the difference between hiring and not hiring is not simply a yard line marker laid down on a football field, but a moat filled with alligators with a high wall on each side. The expected benefits of actually hiring a worker must be both substantial and low risk.

Regards, Don

Les Cargill writes:

But isn't this just a specific form of the question "what is deflation"?

Productivity has a deflationary effect. We're up better than 3:1 for industrial workers alone since 1975 - never mind nonindustrial/service workers ( who can presumably be even more productive).
Meanwhile median incomes look to be flat, AJI.

Yeah, the Fed blows bubbles to try to counteract the general, frog-boiling deflation we're all in. This is all the *intended* effect of the Humphrey-Hawkins bill of '78 - to inflate in order to oppose deflation. When you need 1/3 the workers to make everything you made in 1975, you'd better have a Next Big Thing to occupy them. This, of course, in my estimation suffers from the Lump of Labor fallacy among other things.

Just a *hint* of unemployment, and people start saving more ( having been told that they were not saving enough anyway for up to thirty years ) and the situation worsens.

Maybe I am wrong - but essentially, Hayek had no story on the very real, observed deflation. But that leads to something very much like Keynsianism, so I'll stop here.

Floccina writes:

(and don't tell me that justifies single-payer health care, because that would simply shift the employer's cost from the health benefits line item to the tax line item)

I have told people that though I am against single-payer health care at this time that if we are to move in that direction we should target 7% of GDP and use monopsony (monopsony is a way to combat excessive licensing indirectly) and evidence based medicine to get there. But as far as i can see higher health care costs should just result in lower wages and not much change in employment because few minimum wage workers health insurance from their employers. Now big rapid change in cost would effect employment due to adjustment.

I had to build my own car or write my own computer operating system,

Think Linux you and thousands of your closest friends can.

Floccina writes:

Oh and one other related thing in times this there is a lot work for cash not declared to the Government as income.

ChrisA writes:

My take is that unemployment during recessions is a supply chain effect. Small changes in ultimate use can cause very large swings in suppliers further up the chain as they get amplified (and misinterpreted). MIT-Sloan have a game they call the "beer game" which illustrates this effect in quite a funny and unbelievable way (when you are a player). See the "bullwhip effect" on Wikipedia.

Take the example of an consumer industry (prime) with current demand of 100 units increasing fairly steadily by 3% per year. To supply the machines to to raise supply by 3 units per year there is an supplier industry, call them Secundus. There is a transient shock to the economy (people get scared by a bank crash) and for one year growth falls to 2%. Prime cuts new investment by 1/3rd but their production still grows, so probably they are still hiring, but at a reduce rate. Secundus however sees an overall 1/3 reduction in orders, they have to cut their workers savagely, even though overall demand in their customer's industry is still going up. Of course Secundus has its own supply industry (Tertius), and the impact gets amplified even further for them, Secundus has 1/3rd overcapacity and they are not going to order anything that year, so that entire Tertius industry could be looking for a new job, until the primary industry recovers its former growth rate. In a way, many supplier industries are highly leveraged to ultimate consumer demand.

fundamentalist writes:

I’m going to assume that by presenting Hayek’s ideas I’m not violating Kling’s prohibition of Austrian ideas because most Austrians have ignored Hayek’s business cycle theory for decades, though I’m not sure why. I have asked quite a few and always get no response.

“I find it useful to think of economic activity as outsourcing. If we eat at each other's restaurants, the labor of the chefs will be measured as economic activity. If we eat at home, our cooking labor will not be so counted.”

That’s part of the problem. You’re model is too small and so doesn’t adequately describe reality. It’s not much different from Krugman’s baby-sitting co-op story. Both focus on the retail sector alone, as if retail is all that there is. However, I doubt you will see much unemployment in the retail sector, or in the consumer goods producing sector, either. The real unemployment takes place in the capital goods sectors of the economy. Even Cantillon noticed this back in the early 1700’s. Every economist afterwards noticed it until Keynes came along and made everyone forget.

And the idea that the retail sector drives every other part of the economy is pure Keynes and a violation of Mill’s principle that the demand for retail goods is not the same as demand for labor. As Mill pointed out, capitalists demand labor to produce things. Consumer demand merely allocates where that investment in labor will be.

So you have to look at why unemployment in the capital goods sectors is so high. For that, you need Hayek’s Ricardo Effect, which modern Austrian econ has abandoned to its harm. The Ricardo Effect is nothing but the microecon textbook example of businesses rationally optimizing the allocation of resources between capital and labor. When labor is cheap, they use more of it and less capital. So when the demand for capital goods falls because labor is so cheap, what happens to the capital goods manufacturers.

Finally, there is one particular insight from Hayek that I think is appropriate. Very few workers today can work without some kind of capital. Even ditch diggers need shovels. A lot of capital gets destroyed in the boom through bad investment decisions. When capital gets destroyed, those workers who depended upon it can no longer get work. It’s as if you had a company that hired 10,000 men to dig ditches with shovels and one day all of the shovels disappeared. It will take a while for savings to accumulate and rebuild the destroyed capital that is needed to re-hire those workers.

Sam writes:
(and don't tell me that justifies single-payer health care, because that would simply shift the employer's cost from the health benefits line item to the tax line item)

Nothing about this justifies single-payer, but you have the mechanics wrong with respect to how it works -- at least in Canada. Health care in Canada is funded by transfer payments from the Federal Government's general fund to the provinces; so ultimately it is funded by personal and corporate federal income taxes, not a specific payroll tax. Effectively, the employer already pays a fraction of every potential employee's health care costs, and this fraction does not change if you hire.

Alan Crowe writes:

As people age they are replaced by the young. The bright
young things join the glamorous industries. For the
technically minded it goes

1750 steam engines, canals
1850 railway engines
1920 automobiles
1960 jet engines

But there are not enough bright young things to go
round. The railways go into a decline in the twentieth
century because they are starved of talent. Shop keeping
declines because the clever son gets a better job, in
computing, while the stupid son stocks the wrong goods,
letting Walmart win.

In this account the marginal employees depend on others
organising their work. The die is cast 20 years before when
the bright twenty-somethings abandon a sector. 20 years later
there is a duff crop of forty-something managers who cannot
organise things well enough to make the marginal employees useful.

In a nutshell: Since there is not enough talent to go round, pay attention to the glamour that seduces the brightest of the next generation. That sets the shape of the economy in twenty years time.

Doc Merlin writes:

Ok, I will present a new idea, it is very simple:

What matter is the time change in marginal cost versus time change in marginal product for firms.

When marginal costs go up faster than marginal product the economy will slow, if it happens for too long the economy will decline. When the marginal products go up faster than marginal costs the economy will accelerate.

This means that fiscal stimulus is not just wholly ineffective, its actually detrimental, because it increases marginal costs more than it increases average marginal product.

Fiscal tax stimulus works in the short run by lowering marginal costs. However, unless it is balanced in a decrease in federal expenditures we get debt problems.

Les Cargill writes:

Doc Merlin:

We are expecting growth to reduce the actual marginal cost of the debt. Really reduce it, in AJI terms, not just by inflation. A billion was a lot of money in 1945; now it's what Ben Bernanke finds in the sofa cushions at the Fed. If marginal productivity is 100x what it was in 1910 or 1900, then all's right with the world - that's a 4.7% growth rate. Or that's the narrative.

But this doesn't necessarily make it more difficult for people to be employed. Deflation, however, does.

Cyberike writes:

I am going to echo Les Cargill because I think part of the reason for the problems in the economy is that we need a lot fewer workers to produce what we need than we once did. We have not yet learned how to set wages appropriately for the most productive among us.

I heard an old saying once: Needs are finite, wants are infinite. Not just our economy, but in large part the economies around the world (think China) have been supplying our wants, and they have been doing so at lower and lower cost due to automation. We essentially picked up the slack by increasing our wants, and therefore our consumption. Now that the economy has retrenched, we are back to consuming only that which satisfies our wants, which we can do at relatively little cost.

How expensive is food and water (for example)? How many workers does it take to satisfy this demand?

The problem is that those workers that are essentially able to supply the demand are not making a wage premium. Put another way, we only need a few productive workers, but they have to support large numbers of the rest of us who are not so productive. Think welfare.

We have not yet reached the state of utopia where we can earn a living by doing nothing. But there is nothing for us to do because, either through luck or skill (meaning they kept their job while we did not), others can do what we can do better than we can do it, and we are simply not needed.

Les Cargill writes:

Cyberike: the infinity of wants is a very core tenet of economics, and if we've managed to violate it somehow, it's only very recently. I fear I did not cadge my text in weasel-ey enough prose - this is but a hypothesis, one that is to be treated with the utmost skepticism, and almost with disdain. It reeks of pungent Utopianism, and is almost an "inverse" Malthusianism/Luddism - not very trustworthy company to be in at all.

Devin Finbarr writes:

The recession starts with a fall in aggregate demand. Perhaps this fall occurred because of a financial crisis, or perhaps it occurs because the Fed tightened.

The question is why does a fall in aggregate demand result in lower output and unemployment, rather than lower prices and lower wages?

The answer is the nature of the aggregate demand shock. When people cut spending, they cut certain areas more than others. They cut durables and luxuries first. In effect the demand curve for any good that's purchase can be delayed goes vertical. People trying cut spending and save will not spend on these goods, no matter what the price. As a result inventory builds up.

Since the industries have built up inventory, and little demand, the industries have no need for the marginal worker. In other words - the value of a marginal worker drops to zero.

That's why you get mass unemployment. It's not sticky wages that cause the problem. It's the fact that workers literally produce no economic value. What's the value of building a new car if the company already has acres of unsold inventory?

Any worker is only valuable in the context of an industry that channels his abilities into making stuff people want. If that industry has a glut, that worker becomes valueless. Until the glut subsides, or the worker can figure out a way to make himself valuable in a different industry that has no glut, that worker will not be able to earn a wage that sustains himself.

Colin K writes:

In good times, we over-estimate the skills people have and the value of those skills.

Because workers are producing organizational capital, it takes a long time to realize that.

In good-to-flat times, firing an employee is a lot of work. To fire them for cause may require a year of negative reviews, and those are hard for everyone. Making the exit voluntary means some kind of buyout which costs money and tends to reflect badly on the manager. There's all the reason in the world to look the other way and hope things improve.

In bad times, it becomes much more obvious who the slow buffalo are, much as crashes tend to reveal investment frauds. At the same time, it becomes praiseworthy for a manager to "make the hard calls" and cut payroll. Poor financial results provide legal air cover and negotiating leverage to bring the cost down.

As an overpaid employee, it stinks to get cut loose at the very moment when every employer is suddenly removing their rose-colored goggles. One of the best things that ever happened to me was when an employer let me go in the fall of 2000 from a software job I was probably under-qualified for. Times were still OK in IT, so I quickly found a new job, which I managed to grow into and keep through 2004 when I started my own business. Had they given me more time and let me go sometime in 2001, my options would have been far worse.

Noah Yetter writes:

No need for new answers, the Austrian/Recalculation explanation is correct.

MernaMoose writes:

Alan Crowe,

Interesting theory you've got.

But there are not enough bright young things to go round. The railways go into a decline in the twentieth century because they are starved of talent.

But as an engineer though I can tell you, there's much more to the decline of railways in the twentieth century than the rough equivalent of saying, pop music changed its tune. There are solid objective reasons for the technology progression you identify (as I presume you must be aware).

The sexy new industries draw in the bright young things with (at least apparently) strong present and future job prospects and pay. But today's sexy industries can turn into tomorrow's Fat Broad. "Emerging technologies" with supposedly bright futures, sometimes die instantly upon exposure to daylight.

Yet as project lead (I'm an engineer thank you and I refuse to consider myself a manager) I've frequently seen the shortage of technology talent drive corporate decision making. It's curious that we always want to hire the best and brightest, and we claim that we do!.

Yet in practice, we frequently find ourselves planning as if we were staffed by people who are on average, below average in abilities. We back off from the more aggressive design paths in choosing what products to develop next, for example, out of fear that we won't be able to provide a sufficiently competent design team (though this is rarely acknowledged in so many words).

Which has always implied to me that people are not so very good at figuring out who the brightest actually are.

But isn't that the gist of it. There is a shortage of talent, and we don't necessarily recognize it when it's standing in front of us.

MernaMoose writes:

Also, I suspect that as work gets more sophisticated, training and orientation costs increase.

I've spent my career in high tech industries, where this is absolutely true. People do keep marginal performers due to the high costs of changing out your horses mid-stream.

Within corporations, Sonic Charmer is right. Managerial head count wars happen. But corporations are such odd creatures. Inside them, you'd almost think that market forces don't exist.

But why do so many people end up unemployed at the same time? Doc Merlin's theory that it comes down to balancing the time derivatives of marginal cost vs marginal product makes a lot of sense to me, yet it doesn't explain the temporal rate changes. We have many suspects in the present down turn, but I'd bet lots that this one makes the short list of Big Hitters:

We've spent the last seventy years increasing the hidden overhead and downside risks associated with hiring a worker -- which meant the minimum revenue-per-employee threshold below which hiring doesn't make sense has crept up and up and up, gradually.

So true, and so sad. But since 9/11, the creep hasn't been so gradual. More like a step change (increase) in the upward slope.

I have watched fully burdened company labor rates climb in recent years, decidedly faster than the apparent rate of inflation (if anyone actually knows what that is?). I've also noticed the more or less continuous generation of new departments and organizations within companies, whose sole purpose is compliance with government regulations and requirements. Need I say these new departments and organizations contribute nothing to the product going out the door, yet companies cannot remain in business without complying.

So labor rates climb and it means that each year you (as a manager) can do less with a given budget. More than once I've wondered, how long can this go on?

I've seen products not get developed, not because they weren't a good idea (meaning there are probable customers) but because the margins just weren't projected to be quite high enough. In theory some smaller or "more efficient" company could have developed them (where today, "more efficient" commonly means "import it from China"). But in practice I believe, some products just don't come to market nearly as soon, or in some cases ever, because rising overhead costs squeeze them out. The Great Unseen.

I think your recalculation theory has a lot of merit. When labor rates go up it forces a recalculation sooner or later. We must decide what we're going to produce, and what we aren't. But the richer we get as a society, I'll venture the theory that recalculation is more complex and takes longer. I'll try to sketch out an example to illustrate why.

Suppose that right now, my taking on Job X would be much more beneficial to the company I work for, than my doing Job Y (which I really want). Job X may or may not be immediately, personally unappealing, but the issue is long term career prospects. The company may make more money over the next five years if I do X, but I can see that beyond that, my career is just going to stall. So by hook or by crook, I figure out how to get myself into Job Y.

Anyone with a few ounces of intelligence, talent, and ambition, can see Job X for what it is. So what happens? Job X is really important to the company right now, but the position gets filled with a marginal quality employee. The better employees just aren't going to do it.

In theory if Job X is important enough, the company could pay more for the position to offset. But in practice this doesn't happen, because Job X can in principle be done by someone with a lower pay grade. So the marginal employee (who can't maneuver himself out of it because he's marginal) gets stuck with Job X, and in five years the company overall is worse off, but my career track is better off.

This plays out to the extreme inside large institutions, but it can't be non-trivial even in small businesses. Someone above said we don't know how to appropriately determine what a given job should pay. I think there's truth to that, though my reasons are different.

As we all grow richer, we as individuals can afford to be on idle longer (including unemployed for a time if that's what it takes), until we've found a position we're willing to accept. So as we grow richer, recalculation takes longer to play out.

Doesn't this imply that the creeping cost of government will lead to longer and longer recessions, as time goes by? Who knows what the period of this cycle is, but it's almost certainly not a constant if you wanted to model it.

Sandwichman writes:

"At best, the hypothesis that non-wage labor costs have risen is a partial explanation for high unemployment."

That "partial explanation" goes further, though, when cycled through the fatigue/leisure/productivity/income/employment effects of the choice between numbers of workers and hours per worker.

As Sydney Chapman showed more than a century ago, there is already a bias toward excessively long hours built into the competitive employment model. Non-wage labor costs intensify that long hours bias. In turn, the excessively long hours act as a perpetual brake on labor income and employment. Nominal productivity gains (e.g., expanding financial services, more intensive exploitation of natural resources) conceal a stagnation of real productivity gains that would come from simply the less wasteful use of labor and natural resources.

[Tiny url revised to full url.--Econlib Ed.]

Daniel Walker writes:

This is not a new idea, but I think The Fair Minimum Wage Act of 2007 hasn't been given due consideration as an explanation for the current high unemployment among low-skilled, "marginal" workers. The minimum wage has been increased by 24% over the past two years. This dramatically rising price floor has crippled the ability for low-skilled labor markets to adapt to changing circumstances. The poor, those with the least to spare, those at the margin all suffer most when they are denied freedom to choose new wage rates while negotiating for new employment.

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