Until Keynes explained the negative feedback at work in labour markets (Keynes 1936 Chapter 3) it had been assumed, quite reasonably, that supply of labour by working people balanced demand for labour by businesses at an appropriate price, which was the real wage for an hour of basic labour, so that full employment was always maintained. The real wage is the value of each hour of basic labour after correction for inflation or deflation, whereas the money wage (also called nominal wage) is the value that varies with inflation or deflation. Different skill levels are dealt with by multiplying up the basic rate so that a person with twice the basic skill is paid at twice the basic real rate. In this argument if there is a shortage of labour (more jobs than workers), then workers move to where higher real wages are paid, which are the more profitable industries, whereas less profitable industries won't be able to afford the higher wages and go out of business. In this way the number of jobs drops until there is a balance at full employment but at a higher real wage than before. If there is a shortage of demand (more workers than jobs), then workers are prepared to work for lower real wages which increases industry profitability allowing production to expand and more jobs to become available, again bringing about a balance at full employment but at a lower real rate than before. This theory works exactly as expected for individual firms, where in many cases for example the setting of a minimum wage is detrimental to their short-term profitability - as they are quick to point out very loudly. At the level of the economy as a whole however the effect is quite different, as will be explained.
Before it was solved it was a puzzle why there should ever be involuntary unemployment - people willing to work for the prevailing real wage but no jobs available for them. Traditional economists solved this problem by assuming that involuntary unemployment didn't exist, any unemployment was a minor and localised aberration due to labour unions asking for too much or to individuals preferring leisure to work at the basic rate. With this mindset of continuous full employment the economy always operated at maximum capacity with all wealth produced being used at the same rate. There could never be a shortage of demand so all economic efforts were directed at improving and extending the supply of wealth, because however much was supplied would always be demanded (this is known as 'Say's Law', first set out by Jean Baptiste Say in 1803[150]). This was not to say that everything produced would be bought. There would always be things produced that people didn't want and wouldn't buy at a profitable price, but such a situation was temporary in that such things would soon stop being produced. The money that was formerly spent by producers in producing them would be available to produce other things that people did want but were temporarily in short supply because insufficient workers were employed in producing them. Hence people employed in producing useless things would soon be re-employed elsewhere in producing useful things. The steady state (equilibrium) was with everything produced being used. Say's Law is based on the assumption that money received for wealth is either immediately spent by the person receiving it on other wealth, or, if money is in short supply for any reason then money substitutes become available and are used instead. The money substitution assumption is examined in chapter 81. If these assumptions hold true then whenever something is produced and sold, it creates an equivalent demand for something else, in effect supply creates its own demand.
That this view was palpably untenable because of many families in dire poverty during the Great Depression in the 1930s didn't cut any ice with such economists. They still preferred to believe that starving people chose leisure over work.[151] Other economists were more open minded and recognised that there was something very important missing in the economic theories of the time that caused a mismatch between expected and actual conditions. One such economist was John Maynard Keynes, who wrestled with the problem and realised the reason for it, setting out his work in his 1936 publication (Keynes 1936).
Keynes' great insight was that the key factor in a depressed economy is not supply but demand - demand can fall short of supply for long periods, so that equilibrium is not in fact necessarily with everything produced being used, but can also occur with far fewer things being produced and used than could be, resulting in high levels of involuntary unemployment and low levels of production. The reason is simply that the assumptions underlying Say's Law don’t always hold (Hahnel 2014 p161). Money received for a sold product is not necessarily spent on other products, it can and often is taken out of circulation, especially when people fear for the future and deliberately don't spend it. This is the situation illustrated in the simple and real economies when one person tries to save money - see chapters 13 and 15. It was believed that the impact of taking money out of circulation was automatically limited because any other product could substitute for money, so as savings in the form of money increased money started to become scarce so people saved other things instead. That people would do this was rejected by Keynes, who argued that when money can't be produced by the population like other products can other products aren't able to substitute for it. This is discussed in more detail in chapter 81.
In these circumstances the involuntarily unemployed are the people who could produce the things that could be used, but they can't, not because they are too stubborn to work for the wages that are on offer, but because there are no jobs on offer because producers fear that their produce won't be sold - Catch 22!
The element that was missing was that what works for any individual group of workers and any single business doesn't work for the economy as a whole. It is a variation on the paradox of thrift. Let's call it the real-wage paradox. The insight was the recognition that workers are also spenders, and that they can only spend what they earn, so a reduction in wages, expected to bring supply into line with demand, also reduces their spending power and hence demand for the very products that their labour is producing. Reduced demand for products means that product prices have to fall, which means that workers' real wages - i.e. adjusted for prevailing price levels - come back up again to a large extent and therefore industry does not become more profitable so it can't make more jobs available. Keynes showed that although workers can agree to reduced money wages (nominal wages), it is not in their power to accept correspondingly reduced real wages because of the negative feedback effect (though Keynes didn't call it that) of their wages on prices.
Furthermore, Keynes showed that far from the labour market always leading to full employment, meaning no involuntary unemployment, it could settle at any level. He showed that in any prevailing situation there is an equilibrium level of output that it is worthwhile for producers to supply, at which level there are sufficient customers who are able to buy and find it worthwhile buying, where more output (some stock remains unsold) or less output (not selling as much as could be sold) than this amount reduces firms' profits. This level need not and often does not correspond to full employment. In this respect full employment represents a special case, where the general case is represented in the title of Keynes great work, 'The General Theory of Employment, Interest and Money'.
He showed that the Great Depression was caused by the economy being trapped in a high unemployment/low productivity trough, from which neither workers nor employers could extricate it. The solution was simple; since workers weren't able to spend, the government must do the spending instead. His policies were adopted (in spite of the finer points of his theory being misunderstood) throughout much of the developed world after the Second World War, and economic growth during that period and levels of employment were substantially higher than afterwards when neoliberal policies took over, see chapter 83 and Skidelsky 2010 pp116-118. Granted there was a great deal of work to do after the dreadful destruction of the war, but without government spending there would still have been a great deal of work to do, and there would have been plenty of people - including very many ex-forces personnel - available to do it, but no-one to create the jobs because no-one could afford to buy the output. It is a situation where no one employer or even several employers can extract the economy from its Catch 22 trap, but the country as a whole can do so when the government has the courage to spend decisively. Similarly increasing the minimum wage has a positive effect for the overall economy because it creates more spending power and therefore more demand, so overall production rises to match it.
Note that Keynes' analysis relates to an economy where all workers spend in the domestic economy - i.e. a closed (not trading with the outside world) economy. In an open economy it relates only to the domestic market, because in export and import markets workers and spenders live in different countries. Here account must be taken of the extent of these markets in correcting for unemployment, because increased spending has two effects:
i. some of the extra spending is on imports, which increases the incomes of foreign workers but does nothing for domestic workers; and
ii. it increases demand for domestic goods which diverts wealth-creating capacity towards the domestic market, thereby displacing export production and reducing export earnings.
Both of these effects reduce the income multiplier - see chapter 16 - that is brought to bear in stimulating the domestic economy. Increased imports and reduced exports also affect negatively the balance of payments, so these factors are very important. These effects are discussed in more detail in chapters 68 and 69.
Given the inability of workers to change their real wages significantly you might wonder, as I did, how any change in real wages can come about. The answer is that during the depression the Catch 22 trap was caused by workers being the main consumers of the economy's output, so their real wages were tied closely to the prices of the products of that output. When wages fell prices also fell, in broadly the same proportion as the proportion of overall output consumed by workers. In an economy where the link is much weaker, as when much of an economy's output is not consumed by workers (exporting economies such as China's or economies geared up to providing for the ruling classes as in medieval times), then real wages can drop to very low levels. In contrast when the proportion of output consumed by workers increases the real wage of workers also increases in similar proportion.