Structural Slumps

The Modern Equilibrium Theory of Unemployment, Interest, and Assets

Paperback

ISBN 9780674843745

Publication date: 09/01/1998

Dissatisfied with the explanations of the business cycle provided by the Keynesian, monetarist, New Keynesian, and real business cycle schools, Edmund Phelps has developed from various existing strands—some modern and some classical—a radically different theory to account for the long periods of unemployment that have dogged the economies of the United States and Western Europe since the early 1970s. Phelps sees secular shifts and long swings of the unemployment rate as structural in nature. That is, they are typically the result of movements in the natural rate of unemployment (to which the equilibrium path is always tending) rather than of long-persisting deviations around a natural rate itself impervious to changing structure. What has been lacking is a “structuralist” theory of how the natural rate is disturbed by real demand and supply shocks, foreign and domestic, and the adjustments they set in motion.

To study the determination of the natural rate path, Phelps constructs three stylized general equilibrium models, each one built around a distinct kind of asset in which firms invest and which is important for the hiring decision. An element of these models is the modern economics of the labor market whereby firms, in seeking to dampen their employees’ propensities to quit and shirk, drive wages above market-clearing levels-the phenomenon of the “incentive wage”—and so generate involuntary unemployment in labor-market equilibrium. Another element is the capital market, where interest rates are disturbed by demand and supply shocks such as shifts in profitability, thrift, productivity, and the rate of technical progress and population increase. A general-equilibrium analysis shows how various real shocks, operating through interest rates upon the demand for employees and through the propensity to quit and shirk upon the incentive wage, act upon the natural rate (and thus equilibrium path).

In an econometric and historical section, the new theory of economic activity is submitted to certain empirical tests against global postwar data. In the final section the author draws from the theory some suggestions for government policy measures that would best serve to combat structural slumps.

Praise

Edmund Phelps’s [book]…is likely to shake the establishment. For while much of what the Columbia University economist (now working at the Russell Sage Foundation) has to say about the ‘natural’ rate of unemployment has been alluded to before, his ambitious explanation of long-term joblessness may serve as a license for intervention in an area where fatalism has long been fashionable.

—Peter Passell, New York Times
As a result [of this book], academic thinking on unemployment (which will be followed in due course by popular thinking on unemployment) may be about to undergo its third decisive shift this century… Structural Slumps is addressed to professional economists. They will regard it as one of the most important books of this decade. But brave non-specialists, provided they have a grounding in the subject and are not deterred by the necessary mathematics, can learn a great deal. With luck they will include some of Keynes’s practical men ‘who are usually the slaves of some defunct economist’. Few economists write as lucidly as Mr Phelps; among those toiling at the theoretical frontier of the subject, he is peerless in this respect. And he is unusual in another way…he writes with a sense of purpose. Mr Phelps’s theory, he lets you know, matters not for its elegance or technical ingenuity—though it has both—but for the new light it sheds on a problem that urgently demands a solution.

—The Economist
Edmund Phelps’s book is a substantial contribution to the analysis of swings in unemployment from one cycle to the next… [It offers] a wealth of insights into the nature of unemployment.

—Mervyn King, Financial Times
[This] project is one of startling ambition, and the book deserves to be widely read and discussed… [Phelps] amply demonstrates how much turns upon a correct understanding of the macroeconomic consequences of market structure. One can only hope that this first bold effort will stimulate others to follow the trail blazed here.

—Michael Woodford, Journal of Economic Literature
For more than twenty years, Edmund Phelps has been making major contributions, from the workings of the natural rate to the implications of customer markets and of efficiency wages. In this book, he puts it all together. This will no doubt become one of the most important books in macroeconomics of the decade.

—Olivier Blanchard, Massachusetts Institute of Technology
Profound thinking on a profound problem. Every macroeconomist will want to consider Phelps’s arguments.

—Lawrence Summers, Under Secretary for International Affairs, Department of the Treasury
This book is nothing less than a complete reformulation of macroeconomic theory, presenting an alternative to both the new neoclassical and the mainstream Keynesian paradigms. Modern themes, heretofore separate developments in theory, are woven together in a sequence of models of compelling clarity and often startling implications: It is not the deviation from the Phelps-Friedman natural rate that is high, but the natural rate itself; contrary to the Keynesian model, welfare-state policies increase unemployment; domestic tax-and-spend policies are contractionary abroad; worldwide deficit spending can be contractionary; high marginal tax rates on labor contribute to unemployment; monetary policy plays little if any sustained role in explaining high real interest rates and high unemployment. These controversial conclusions are supported by empirical tests.

—Pentti Kouri
An important contribution to economic knowledge—not only offers a new way of understanding long slumps, but also has striking policy implications that are generally overlooked.

—Dennis J. Snower, Birkbeck College, University of London

Author

Edmund Phelps won the 2006 Nobel Prize for Economics for deepening our understanding of the relationship between short-run and long-run effects of economic policy. He is Director of the Center on Capitalism and Society at Columbia University and author of many books, including Inflation Policy and Unemployment Theory, Structural Slumps, and Mass Flourishing.