The most critical number that politicians will watch as they campaign this year is the unemployment rate. On Friday, we woke up to the news that the US economy had added 243,000 jobs in January, which unexpectedly reduced the unemployment rate to 8.3% from 8.5%1. Wall Street greeted the news with a handsome surge – the Dow Jones industrial average jumped 157 points, while the tech-heavy index, NASDAQ, closed at an 11-year high1. As news organizations speculate how the rosy jobs report will recalibrate electoral politics in the coming months2, perhaps this is a good time to discuss the more fundamental issue of what causes companies to hire in the first place. I think a clear understanding of this issue is important if we are to accurately judge how the policies of a particular administration could influence job creation.
There is an often-quoted passage in Adam Smith’s book, The Wealth of Nations, which describes the work in an 18th century pin factory: “One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head…I have seen a small manufactory of this kind where ten men only were employed…Those ten persons… could make among them forty-eight thousand pins in a day…But if they had all wrought separately and independently…they could not each of them make twenty, perhaps not one pin a day…” Here, Smith illustrates how the division of labor serves two purposes – on the one hand, it simplifies the task of each individual worker, and on the other, it vastly improves productivity. However, improving productivity is not an end in itself. The key here is to examine why a company would go through the trouble of making 48000 pins a day. It would do so because there was a demand for those pins (in all likelihood, the demand was much larger), and because meeting that demand would maximize its earnings. This principle holds true even today. Companies will hire only when they think that hiring will allow them to meet the demand for their products, and thereby, increase their profits.
And what determines demand? We go shopping when we have the money to buy the things we need. In other words, demand is determined by our incomes. When our incomes grow, we tend to spend more, and demand remains high. But when incomes contract, as they do in a recession, demand falls. Why then would companies increase their payrolls? They wouldn’t. And so, workers get laid off. This further worsens the economy. How we escape this downward spiral should be the topic for another day; however, the fact that companies hire when hiring is profitable doesn’t necessarily mean that they will hire whenever they make a profit, or that they always need to hire in order to make a profit. For instance, while Adam Smith’s ten man pin factory could only produce 48000 pins a day, by the end of the 19th century, the entire process had been mechanized so that one person presided over the entire operation and cranked out more than 1 million pins a day! 3 In this case, investing in technology, and not employment, drives a company’s prosperity. For a modern example, we need look no further than either the US GDP or the main US stock indexes. Both have almost recovered to or exceeded pre-recession levels, only with about 6 million fewer employees despite an increase in working-age population4.
Candidates running for office this year have offered a number of proposals to address the nation’s unemployment woes. We should carefully evaluate these proposals based on their long-term prospects for American prosperity. For instance, would cutting taxes really guarantee a reduction in unemployment? If so, why hasn’t it worked in the last decade? Would companies really use the offered tax credits to expand if there is no demand? What would a government stimulus do to our national debt? It is time to sift the wheat from the chaff!