The "free market" capitalist (or neo-classical or neo-liberal or "Austrian") argument is that unemployment is caused by workers' real wage being higher than the market clearing level. Workers, it is claimed, are more interested in money wages than real wages (which is the amount of goods they can by with their money wages). This leads them to resist wage cuts even when prices are falling, leading to a rise in their real wages. In other words, they are pricing themselves out of work without realising it (the validity of the claim that unemployment is caused by high wages is discussed in the next section).

From this analysis comes the argument that if workers were allowed to compete 'freely' among themselves for jobs, real wages would decrease. This would reduce production costs and this drop would produce an expansion in production which provides jobs for the unemployed. Hence unemployment would fall. State intervention (e.g. unemployment benefit, social welfare programmes, legal rights to organise, minimum wage laws, etc.) and labour union activity according to this theory is the cause of unemployment, as such intervention and activity forces wages above their market level, thus increasing production costs and "forcing" employers to "let people go."

Therefore, according to neo-classical economic theory, firms adjust production to bring the marginal cost of their products (the cost of producing one more item) into equality with the product's market-determined price. So a drop in costs theoretically leads to an expansion in production, producing jobs for the "temporarily" unemployed and moving the economy toward a full-employment equilibrium.

So, in neo-classical theory, unemployment can be reduced by reducing the real wages of workers currently employed. However, this argument is flawed. While cutting wages may make sense for one firm, it would not have this effect throughout the economy as a whole (as is required to reduce unemployment in a country as a whole). This is because, in all versions of neo-classical theory, it is assumed that prices depend (at least in part) on wages. If all workers accepted a cut in wages, all prices would fall and there would be little reduction in the buying power of wages. In other words, the fall in money wages would reduce prices and leave real wages nearly unchanged and unemployment would continue.

Moreover, if prices remained unchanged or only fell by a small amount (i.e. if wealth was redistributed from workers to their employers), then the effect of this cut in real wages would not increase employment, it would reduce it. For people's consumption depends on their income, and if their incomes have fallen, in real terms, so will their consumption. As Proudhon pointed out in 1846, "if the producer earns less, he will buy less. . . [which will] engender. . . over-production and destitution" because "though the workmen cost you [the capitalist] something, they are your customers: what will you do with your products, when driven away by you, they shall consume no longer? Thus, machinery, after crushing, is not show in dealing employers a counter-blow; for if production excludes consumption, it is soon obliged to stop itself." [System of Economical Contradictions, p. 204, p. 190]

However, it can be argued, not everyone's real income would fall: incomes from profits would increase. But redistributing income from workers to capitalists, a group who tend to spend a smaller portion of their income on consumption than do workers, could reduce effective demand and increase unemployment. As David Schweickart points out, when wages decline, so does workers' purchasing power; and if this is not offset by an increase in spending elsewhere, total demand will decline [Against Capitalism, pp. 106-107]. In other words, contrary to neo-classical economics, market equilibrium might be established at any level of unemployment.

But in "free market" capitalist theory, such a possibility of market equilibrium with unemployment is impossible. Neo-liberals reject the claim that cutting real wages would merely decrease the demand for consumer goods without automatically increasing investment sufficiently to compensate for this. Neo-classicists argue that investment will increase to make up for the decline in working class consumption.

However, in order make this claim, the theory depends on three critical assumptions, namely that firms can expand production, that they will expand production, and that, if they do, they can sell their expanded production. This theory and its assumptions can be questioned.

The first assumption states that it is always possible for a company to take on new workers. But increasing production requires more than just labour. If production goods and facilities are not available, employment will not be increased. Therefore the assumption that labour can always be added to the existing stock to increase output is plainly unrealistic.

Next, will firms expand production when labour costs decline? Hardly. Increasing production will increase supply and eat into the excess profits resulting from the fall in wages. If unemployment did result in a lowering of the general market wage, companies might use the opportunity to replace their current workers or force them to take a pay cut. If this happened, neither production nor employment would increase. However, it could be argued that the excess profits would increase capital investment in the economy (a key assumption of neo-liberalism). The reply is obvious: perhaps, perhaps not. A slumping economy might well induce financial caution and so capitalists could stall investment until they are convinced of the sustained higher profitability while last.

This feeds directly into the last assumption, namely that the produced goods will be sold. But when wages decline, so does worker purchasing power, and if this is not offset by an increase in spending elsewhere, then total demand will decline. Hence the fall in wages may result in the same or even more unemployment as aggregate demand drops and companies cannot find a market for their goods. However, business does not (cannot) instantaneously make use of the enlarged funds resulting from the shift of wages to profit for investment (either because of financial caution or lack of existing facilities). This will lead to a reduction in aggregate demand as profits are accumulated but unused, so leading to stocks of unsold goods and renewed price reductions. This means that the cut in real wages will be cancelled out by price cuts to sell unsold stock and unemployment remains.

So, the traditional neo-classical reply that investment spending will increase because lower costs will mean greater profits, leading to greater savings, and ultimately, to greater investment is weak. Lower costs will mean greater profits only if the products are sold, which they might not be if demand is adversely affected. In other words, a higher profit margins do not result in higher profits due to fall in consumption caused by the reduction of workers purchasing power. And, as Michal Kalecki argued, wage cuts in combating a slump may be ineffective because gains in profits are not applied immediately to increase investment and the reduced purchasing power caused by the wage cuts causes a fall in sales, meaning that higher profit margins do not result in higher profits. Moreover, as Keynes pointed out long ago, the forces and motivations governing saving are quite distinct from those governing investment. Hence there is no necessity for the two quantities always to coincide. So firms that have reduced wages may not be able to sell as much as before, let alone more. In that case they will cut production, adding to unemployment and further lowering demand. This can set off a vicious downward spiral of falling demand and plummeting production leading to depression (the political results of such a process would be dangerous to the continued survival of capitalism). This downward spiral is described by Kropotkin (nearly 40 years before Keynes made the same point in his General Theory of Employment, Interest and Money):

"Profits being the basis of capitalist industry, low profits explain all ulterior consequences.

"Low profits induce the employers to reduce the wages, or the number of workers, or the number of days of employment during the week. . . [L]ow profits ultimately mean a reduction of wages, and low wages mean a reduced consumption by the worker. Low profits mean also a somewhat reduced consumption by the employer; and both together mean lower profits and reduced consumption with that immense class of middlemen which has grown up in manufacturing countries, and that, again, means a further reduction of profits for the employers." [Fields, Factories and Workshops Tomorrow, p. 33]

Thus, a cut in wages will deepen any slump, making it deeper and longer than it otherwise would be. Rather than being the solution to unemployment, cutting wages will make it worse (we will address the question of whether wages being too high actually causes unemployment in the first place, as maintained by neo-classical economics, below). Given that, as we argued in section C.7.1, inflation is caused by insufficient profits for capitalists (they try to maintain their profit margins by price increases) this spiralling effect of cutting wages helps to explain what economists term "stagflation" — rising unemployment combined with rising inflation (as seen in the 1970s). As workers are made unemployed, aggregate demand falls, cutting profit margins even more and in response capitalists raise prices in an attempt to recoup their losses. Only a very deep recession can break this cycle (along with labour militancy and more than a few workers and their families). Working people paying for capitalism's contradictions, in other words.

All this means that working class people have two options in a slump — accept a deeper depression in order to start the boom-bust cycle again or get rid of capitalism and with it the contradictory nature of capitalist production which produces the business cycle in the first place (not to mention other blights such as hierarchy and inequality).

The "Pigou" (or "real balance") effect is another neo-classical argument that aims to prove that (in the end) capitalism will pass from slump to boom. This theory argues that when unemployment is sufficiently high, it will lead to the price level falling which would lead to a rise in the real value of the money supply and so increase the real value of savings. People with such assets will have become richer and this increase in wealth will enable people to buy more goods and so investment will begin again. In this way, slump passes to boom naturally.

However, this argument is flawed in many ways. In reply, Michal Kalecki argued that, firstly, Pigou had "assumed that the banking system would maintain the stock of money constant in the face of declining incomes, although there was no particular reason why they should." If the money stock changes, the value of money will also change. Secondly, that "the gain in money holders when prices fall is exactly offset by the loss to money providers. Thus, whilst the real value of a deposit in bank account rises for the depositor when prices fell, the liability represented by that deposit for the bank also rises in size." And, thirdly, "that falling prices and wages would mean that the real value of outstanding debts would be increased, which borrowers would find it increasingly difficult to repay as their real income fails to keep pace with the rising real value of debt. Indeed, when the falling prices and wages are generated by low levels of demand, the aggregate real income will be low. Bankruptcies follow, debts cannot be repaid, and a confidence crisis was likely to follow." In other words, debtors may cut back on spending more than creditors would increase it and so the depression would continue as demand did not rise. [Malcolm C. Sawyer, The Economics of Michal Kalecki, p. 90]

However, even if we ignore this the capitalist argument is still likely to be wrong as it the "conventional economic analysis of markets . . . is unlikely to apply" to the labour market and as a result "wages are highly unlikely to reflect workers' contributions to production." This is because economists treat labour as no different from other commodities yet "economic theory supports no such conclusion." At its most basic, labour is not produced for profit and the "supply curve for labour can 'slope backward' — so that a fall in wages can cause an increase in the supply of workers." In addition, as noted at the end of section C.1.4, economic theory itself shows that workers will not get a fair wage when they face organised or very powerful employers unless they organise unions. [Keen, Debunking Economics, pp. 111-2 and pp. 118-9]

The idea of a backward sloping supply curve for labour is just as easy to derive from the assumptions used by economists to derive their standard one. This is because workers may prefer to work less as the wage rate rises as they will be better off even if they do not work more. Conversely, very low wage rates are likely to produce a very high supply of labour as workers need to work more to meet their basic needs (this was a key aim of state intervention during the rise of capitalism, incidentally). This means that the market suply curve "could have any shape at all" and so economic theory "fails to prove that employment is determined by supply and demand, and reinforces the real world observation that involuntary unemployment can exist" as reducing the wage need not bring the demand and supply of labour into aligment. While the possibility of backward-bending labour supply curves is sometimes pointed out in textbooks, the assumption of an upward sloping supply curve is taken as the normal situation but "there is no theoretical — or empirical — justification for this." [Op. Cit., pp. 121-2]

Sadly for the world, this assumption is used to draw very strong conclusions by economists. The standard arguments against minimum wage legislation, trade unions and demand management by government are all based on it. Yet, as Keen notes, such important policy positions "should be based upon robust intellectual or empirical foundations, rather than the flimsy substrate of mere fancy. Economists are quite prone to dimiss alternative perspectives on labour market policy on this very basis — that they lack any theoretical or empirical foundations. Yet their own policy positions are based as much on wishful thinking as on wisdom." [Op. Cit., p. 123] Within a capitalist economy the opposite assumption to that taken by economics is far more likely, namely that there is a backward sloping labour supply curve. This means that a fall in real wages may increase the supply of labour as workers are forced to work longer hours or take second jobs simply to meet their basic needs. In other words, the labour market is not a market, i.e. it reacts in different ways than other markets.

So, as Schweickart, Kalecki, Keen and others correctly observe, such considerations undercut the neo-classical contention that labour unions and state intervention are responsible for unemployment (or that depressions will easily or naturally end by the workings of the market). To the contrary, insofar as labour unions and various welfare provisions prevent demand from falling as low as it might otherwise go during a slump, they apply a brake to the downward spiral. Far from being responsible for unemployment, they actually mitigate it. This should be obvious, as wages (and benefits) may be costs for some firms but they are revenue for even more.