Inflation and Unemployment

One of the more exasperating aspects of mainstream economics is how it justifies using inflation to combat unemployment. Before getting into this, let us examine the curious modern phenomenon of mass unemployment.

Since human wants are insatiable, the demand for labor is inexhaustible. There is always work to be done. On the free market, the demand for and supply of labor will establish a spectrum of wage rates such that all those who want to work can find jobs and all those who need labor can acquire it. This does not mean that everyone can find a job to their liking at a wage rate they desire. It simply means that they will be able to find employment and at a wage rate equivalent to their marginal productivity. Correspondingly for an employer, he may not be able to hire the best man for the job, but he will be able to hire someone at a wage rate that is equivalent to their marginal productivity. In other words, on an unhampered market, the prevailing wage rate will clear the market and thus permanent mass unemployment cannot occur.

We note that there will always be temporary unemployment as capital shifts from industries no longer favored by consumers to those that are. Such shifts require workers to move in order to find jobs. As this takes time, there will be some temporary unemployment.

Let us see what happens when governments tamper with the market. If the prevailing wage rate is forced upward beyond what it would be on the free market, the supply of and demand for labor will be out of sync. For some workers, their now higher wage rates will not be equivalent to their marginal productivity and thus their continued employment means losses for their employers. At some point, the losses become severe enough that employers are forced to curtail production and scale back employment. Thus, mass unemployment appears.

How do governments force up wage rates? There are two primary methods. The first is somewhat obsolete in the US but is still a factor in some other countries. This method is via union bargaining. There is nothing inherently wrong with unions. They only become problematic when they are supported by the state such that employers are forced to deal with them, are prevented from hiring non-union workers, and the state purposely fails to deal with union violence as it does with violence perpetrated by the rest of society. This privileged position of unions, which is only possible with the connivance of the state, allows them to put upward pressure on wages. Of course this is great for the union workers who have jobs but no so good for everyone else.

The second method by which governments push up wage rates is by minimum wage laws.

With the emergence of mass unemployment there was inevitably a call for governments to do something about it. Oddly, virtually all economists publicly acknowledged that mass unemployment was caused by a prevailing wage rate that was too high. Additionally, it was readily acknowledged that the only solution was to decrease wage rates. Unfortunately, how to accomplish this was a point of contention. To Austrian economists, the solution was obvious: allow the free market to work. However, this is politically difficult in modern democratic republics. The solution favored by the rest of the economics profession was interventionism via inflation. The rationale for claiming that inflation can cure mass unemployment has changed over time.

In a collection of excellent essays by von Mises, published as Economic Freedom and Interventionism, he described the original Keynesian rationale for using inflation to achieve full employment. This form of interventionism gained ground during the 1920s and became orthodox by the 1930s. Note that as usual, Keynes was not the first to propose this “Keynesian” solution. The idea is both clever and diabolical. Since the public, and especially unions of that time, would balk at a reduction in nominal wages, they can be tricked into accepting a reduction in real wages by reducing the purchasing power of the monetary unit. As long as the general public remained gullible, this policy could work.

However, there are two devastating problems. First, inflation upsets the inter-temporal coordination of the production structure. Those who acquire the newly created fiduciary media such that their incomes rise before the prices of goods and services they consume rise win. Those in the opposite situation lose. Also, the temporary boom must result in a slump. Additionally, if the inflation continues at an ever increasing rate, eventually the flight to real values occurs, the populace abandons the currency, the currency regime is destroyed, and social chaos ensues. This seems to be a steep price to pay to avoid the political problem of allowing the free market to correct wage rages.

The second problem is more obvious, the public cannot be fooled forever. At some point, they wake up and demand price index clauses in employment contracts to prevent a fall in real wages. This in fact occurred with the ubiquitous cost of living raises common in many countries.

As we will see, the first objection to the original “Keynesian” method of combating unemployment has not made an impact on mainstream economics. The second objection became so evident that this rationale was abandoned.

Since the interventionists who constitute mainstream economics still, to this day, refuse to allow the free market to work to prevent mass unemployment and since all of them are inflationists (a polite euphemism for the older designation of monetary cranks) they were forced to dream up another reason for how inflation can combat mass unemployment. This new rationale is Bernanke’s wealth effect. Increasing the circulation of fiduciary media to elevate the prices of capital goods, such as housing, and titles to capital, stocks, increases the wealth of society at large. As the public realizes this increase in paper wealth, they will open up their pocket books and increase consumption. Such consumption will spur business to increase hiring and thus unemployment will decrease. What a clever idea!

Let us pursue a number of objections. First, note that the mechanism, namely inflation, is the same as the previously failed methods of combating unemployment. Proposing a new theory does not change the fact that the policy itself has always failed in the past. As the saying goes, doing the same thing over and over again and expecting a different result is an indication of insanity.

A more fundamental objection is that economic growth can only be achieved by a rate of increase of capital greater than that of population. In other words, the hallmark of a growing economy is a continual rise in capital per capita. Since an increase in fiduciary media does not result in an increase in capital, such a policy cannot result in real economic growth and the economy cannot grow itself out of the unemployment problem.

Also, inflationism may “work” in the short run by sparking a boom. However, as explained above, it cannot work in the long run as a slump is inevitable and mass unemployment must appear again.

When Bernanke’s wealth effect inevitably fails, what will be the next rationale for the inflationists?

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