Capital stock and its impact on unemployment in Chile

Introduction

Since reversals of inflations shocks happened on
seventies were not able to reduce the unemployment rate, which
remained high even though the reversals reduced the oil price and
inflation in general, the supported relationship between
inflation and unemployment was questioned as a main explanation
of unemployment. In addition, the continuously decrease in real
salaries during 1990s in some European countries has not had the
expected effect of arising the employment levels, therefore
labor-wage elasticity theory has not worked at all. All of above
has encouraged to labor economist to find alternative
explanations on unemployment phenomena. On this path, labor
markets regulations, international trade, productivity changes
and investment have arisen as feasible causes of
unemployment.

Even though labor market regulations have been
highlighted as one of the most important variable affecting labor
demand because the expected negative impact of market rigidities
on employment, the economical research has not been able to reach
conclusive evidence. Then, capital stock, between other
variables, has been researched as affecting the unemployment
rates, getting a significant amount of positive evidence. Its
relevance as an explanatory variable rests on the Keynesian
assumption regarding the influence of good markets over labor
markets which would not be able to explain the unemployment just
by itself. As a consequence, this study intends to describe how
the capital stock affects the employment level by reviewing the
concerned theory and by analyzing the empirical evidence.
Finally, a conceptual analysis over the particular Chilean case
is done.

Economic theory

According to the Keynesian point of view, it is not
possible to solve the unemployment phenomena for using policies
and tools operating only from the labor market, especially when
we find ambiguous outcomes from the literature concerned to labor
market institutions" impact on labor demand (Stockhammer, 2010;
Arestis et.al. 2007). In difference to classical studies
undertaken by Layard, Nickell and Jackman (1991) about
unemployment in the UK which assumes that changes in labor market
institutions would lead to changes in the supply-side equilibrium
independently from any variations in the level of economic
activity, Keynesianism assumes a NAIRU continually changing
because investment is always causing the capital stock to vary.
Thus, because the pace of investment is always being influenced
by the level of economic activity, the variability of NAIRU will
be influenced continually by the path of aggregate demand
(Stockhammer and Klar, 2010; Arestis et.al. 2007; Karanassou and
Sala, 2008).

How does capital stock affect unemployment? Even though
the channels identified can differ among researchers, most of
them can be classified into three main streams (Stockhammer and
Klar, 2010). Firstly, following the Keynesian assumption telling
that the level of output and employment as a whole depends on the
amount of investment (Bellais, 2004), is argued that capital
accumulation may play a role as a demand factor: investment is
the most volatile of the macroeconomic aggregates and is
considered the driving variable in business cycle theory as well
as in growth theory (Stockhammer and Klar, 2010; Stockhmammer,
2011). According to Malley and Moutos (2001), nonetheless, we
need to take into consideration that the strength of relationship
capital stock – unemployment will decrease (almost
horizontal in terms of correlations) if unemployment is nearly
frictional (lower rates of unemployment).

Secondly, elasticity of substitution between capital and
labor is presented as being lower than classical economics says
(Rowthorn, 1999; Malley and Moutos, 2001; Stockhammer and Klar,
2010). Lower substituibility, which is assumed in a CES
production function (figure 1), is quite relevant is order to
explain why a Cobb-Douglas function fails to predict the labor
market performance when it says that only wages varies nor
employment level when capital stock becomes higher (Kapadia,
2005; Rowthorn, 1999). This lack of substituibility can be
demonstrated by arguing that as effects of demand shocks on
employment and investment are reversed unemployment may not fall
to previous levels due to insufficient capital (Arestis et.al.
2007; Kapadia, 2005).

Figure 1

Comparison between Cobb-Douglas and CES
function performances by introducing increases in
capital

stock.

Source: Graphs taken from
Kapadia (2005), pp. 5 and 6.

Third channel says that there would be a bargaining
effect. Rowthorn (1995) argues that "unemployment reduces the
ability of workers to push up wages, while excess capacity limits
the ability of firms to raise prices" (p. 28). Thus, an
insufficient capital stock will require a higher unemployment
rate to equilibrate income claims of workers and employers. In
this sense, the capability of capital stock to diminish the
unemployment is an issue concerned to medium and long term
because in short run changes in capital stock are not feasible
(Arestis and Biefang-Frisancho, 2000).

As a result of all of these theoretical assumptions,
Stockhammer (2011) claims that effective labor demand need not be
downward sloping at all. Given that main variable affecting
unemployment would be capital stock, increases in wage can rise
the aggregate demand because wage earners are likely to have a
higher consumption propensity than earners of profit income
(upward sloping of labor demand hypothesis is supposed to work in
profit maximization firms based markets).

Evidence

We can summarize the evidence found by classifying three
types of findings supporting the theoretical mainstreams
assumptions and having relevant methodological implications.
Firstly, the hypothesized relationship between capital stock
and unemployment has been strongly supported by empirical
research. It has been demonstrated, for instance, that countries
that experienced the largest slowdown in capital accumulation per
labor hour faced the highest unemployment rates in the 1990s
(Arestis et.al 2007). On the same path, Karanassou and Sala
(2008) state that if capital stock growth had not increased as it
did from 1993 to 2006, unemployment in Australia would have ended
the period about 5 percentage points higher than it actually did.
In a cross Nordic countries study, Karanassou et.al. (2008) found
that capital stock explains around 30% of the increase in
unemployment in Denmark whereas in Sweden, capital accumulation
contributes to 50% of the unemployment during the 1990s. The same
trend was found by Kee et.al. (2005) who aims that capital
accumulation in the export sector explains most of the decline in
Singapore"s unemployment rate.

Secondly, in terms of comparative research between
capital accumulation and LMRs impacts on labor demand,
Arestis et.al. (2007), by estimating cointegrating relationships,
found that capital stock has the most consistent impact of all
the variables included in the estimations of the unemployment
relationship such as wage flexibility, long-term unemployment,
militancy and benefit provision. Stockhmammer and Klar (2010)
performed a panel data analysis for OECD countries controlling a
set of OECD-LMRs and found strong capital accumulation effects,
substantial effects of interest rates, but very small effect of
LMRs. On the same path, Kapadia (2005) demonstrated that capital
stock has an stronger impact on unemployment than labor
institutions by comparatively testing labor market implications
for both Cobb-Douglas and CES production functions.

Finally, in terms of research regarding capital stock
and economic policy, it has been found that interest rates
have empirically important effects on unemployment. For instance,
Stockhammer (and Klar, 2010; 2011) states that "macroeconomic
variables have a much greater impact and among these capital
accumulation and the real interest rate are the most important
ones" (pp. 455). Malley and Moutos (2001) conclude that policies
encouraging a faster rate of capital accumulation should be a
necessary component of any policy package against the
unemployment. Kapadia (2005) argues that policy implications in
order to reduce equilibrium unemployment can be significant since
the reduction in unemployment in countries such as United Kingdom
and Netherlands (which presented investment booms during the 90s)
has been sustained long after investment rates have
fallen.

In spite of this robust evidence confirming the positive
impact of capital stock on employment, other research offer
alternative explanations. Malley and Moutos (2001), for instance,
say that impact of absolute growth rate of capital stock in
OECD-European countries has been less determinant that relative
evolution of capital stock to other countries because an increase
in the domestic capital stock relative to the foreign capital
stock would allow to domestic firms to compete more effectively
by capturing market shares at the expense of foreign firms.
However, there are not enough studies testing this assumption. By
the other hand, Kapadia (2005) also confirms the negative impact
of capital stock on unemployment but its study limits this impact
over a certain range.

Methodological
Issues

Methodologically, there would be a tendency to examine
the influence of capital stock on unemployment by using
time-series methods and usually these studies do not analyze
together both capital stock and LMRs impacts because time-series
data is only available for a small number of LMRs (Stockhammer
and Klar, 2010). Another methodological characteristic of capital
stock studies is they usually use single unemployment rate
equations and proxy variables such as real interest rates, real
balances or investment ratios (Karanassou and Sala, 2008). For
instance, Stockhammer (2011) offer us the following equation
where LMI, ACCU and MS represent labor market
institutions, capital accumulation and macroeconomic shocks,
respectively. C represents other control variables to be
specified later. FEt and FEj are crosssection
and period fixed effects, respectively.

However, according to Karanassou and Sala (2008) this
trend for using single-equation estimation brings implicitly two
problems: (1) the proxies could not capture the effects of
capital accumulation of other influences due to often the
influence of capital stock is hidden behind noncontroversial
accounts of the unemployment upturns due to rises in interest
rates or financial crises. (2) Since the unemployment rate is a
nontrended variable, single equation models have to use exogenous
variables that do not display a trend. This would not the case
with multi-equation labor market models.

Capital stock and
unemployment performance in Chile

Unfortunately there is not research analyzing the
capital accumulation impact on labor demand in Chile. However, by
simply analyzing the trends of unemployment and growth of capital
stock, an inverse relationship between both of them variables can
be argued (figure 2). As we can see, an opposite trend from 1987
to 2006 is seen by putting together the corresponding curves.
This trend, however, is not kept regarding last three years when
both unemployment and growth of capital stock follow the same
increasing direction. A possible explanation can be provided by
Kapadia´s assumption (2005) which aims increases in
unemployment can be sustained long after reduced investment
rates.

Figure 2

Evolution of unemployment rate and growth
of capital stock in Chile (1987 – 2009)

Source: Statistical Database of
Central Bank of Chile

The inverse relationship between capital stock and
unemployment is confirmed by running a simple correlation
analysis. As we can see in figure 3, a strong correlation
coefficient of -0.48 is obtained which indicates a closely
negative relationship between both of them variables. This
correlation is on the path of Karanassou et.al.´ studies
regarding Nordic countries (2008).

Figure 3

Correlation between unemployment rate and
growth of capital stock (1987 – 2009)

Source: Own calculations using
data from Central Bank of Chile

A possible explanation about this trend can be obtained
by analyzing shares of capital growth by types of capital stock
in Chile (table 1). As we can see, both housing and rest of
construction (share of 74% together) show a steady trend through
the time in difference with machinery and equipment, which shows
significant variation among several periods. Following the
theoretical assumptions previously reviewed (Rowthorn, 1999;
Malley and Moutos, 2001; Stockhammer and Klar, 2010; Kapadia,
2005), lower substituibility could be determining a lower
unemployment as a higher growth in capital stock is introduced in
Chile because most steady and biggest shares of capital stock are
related to assets (housing and rest of constructions) which
cannot as easily replace labor as machinery and
equipment.

Table 1

Growth of capital stock evolution by type
of capital (1987 – 2008)

Source: Statistical Database of
Central Bank of Chile

Conclusions

Even though the evidence seems to be quite robust in
order to confirm a negative relationship between capital
investment and unemployment, into economic theory still remain a
considerable amount of open questions underlying this
relationship. The lack of research does not still allows to
define precisely which is the channel underlying the impacts on
labor demand although the lower elasticity of substitution
between capital and labor has been widely demonstrated by
empirical evidence. Thus, the classical assumption arguing that a
high elasticity of substitution determines the presence of a
Cobb-Douglass production function, which gives more importance to
labor market institutions as unemployment determinants, has been
almost rejected.

The implications of these findings by economic policy
also has been discussed, concluding that empirical evidence
permits to argue a relevant impact from fiscal and monetary
policy on unemployment through both interest rate and capital
accumulation.

Finally, even though time-series studies analyzing the
relationship between capital stock and unemployment are needed
for the Chilean case, a simple correlation model can initially
demonstrate a negative relationship which could be determined by
a lower elasticity of substitution between capital and labor
(such as is predicted by the theory) supported in a massive share
of capital stock in non-renewable assets in the short
term.

References

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Arestis, Phillip; Baddeley, Michelle and Sawyer,
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Stockhammer, Engelbert. 2011, "Wage norms, capital
accumulation and unemployment. A Post Keynesian view",
forthcoming in Oxford Review of Economic Policy, Version
2.0 (School of Economics, Kingston University).

Autor:

RodrigoValdivia Lefort

Writing Economic Reports – MA Business
Economics

Module Leader: José Sanchez
Fung

London, May 2011