What is the real connection between inflation and unemployment? Then again, maybe that should be inflation and employment. That this has been raised several time on this site which got me thinking about a 1993 study called The Costs of Unemployment in Australia1 by Raja Junankar and Cezary Kapuscinski. The authors, both of whom are Keynesians, argued that a “fight inflation first” policy generally incurs more costs than benefits, a view that is held by most of the economics profession.
As I recall, this study elicited a favourable response from our media. The striking thing — in my view — is that though 22 years has passed it seems that not a single free market commentator made an effort to establish a link between inflation, booms and the consequent unemployment. What we do get is the likes of P. D Jonson, Peter Smith, Des Moore, Sinclair Davidson and Steve Kates2, etc., falsely asserting that the so-called boom-bust cycle is a natural part of the free market order and that we will just have to grin and bear it. (This attitude is music to the ears of the left and Keynesians because to them it justifies their own so-called solutions to the problem of recurring recessions).
If one accepts Steve Kates’ view — as does our free market commentariat — then it becomes self-evident why our own free marketers fail to see the fundamental flaws in the Keynesian argument that the cost in terms of unemployment and the lost output of fighting inflation are too high. Someone from the Austrian school of economics would have immediately pointed out these types of studies display a startling degree of ignorance of those aspects of monetary and capital theory that render these studies theoretically worthless, if not actually dangerous.
The Keynesian assumption — and one shared by our economic commentariat and monetarists — is that to all intents and purposes money is neutral in the sense that increases in the quantity of money only influence the price level and is therefore irrelevant with respect to individual prices, thus leaving the structure of relative prices largely unaffected. (A capital structure has no meaning for Keynesians or monetarists). This is a gross error and one largely shared by the great majority of economists. Another gross error is the treatment of capital as a homogeneous blob and not a heterogeneous structure.
In general economists miss the vitally important fact that inflation will alter the structure of relative prices; meaning that prices will not change at the same time or to the same extent3. The effect of driving the rate of interest below the market rate is to expand the demand for credit4, a fact fully understood by the classical economists as was its consequences5, regardless of what Steve Kates preaches. This process distorts the capital structure by creating malinvestments6, i.e., investments that would not ordinarily pay for themselves and would therefore not be undertaken unless there was a fall in interest rates7.
As the much maligned Austrian School continually points out new money is usually injected into the economy at different points. These monetary injections change the distribution of the money stream between all the stages of production. (A process brilliantly analysed by Richard Cantillon). The result is that labour and capital are misdirected into lines of production whose activities are become dependent on increasing the quantity of money. Once the central bank is forced to apply the monetary brakes8, as eventually it must, the misdirected labour and capital (the malinvestments) reveal themselves in the form of excess capacity and rising unemployment, just as the classical school predicts.
It follows that the critics of a “fight inflation first” policy are committing a serious and inexcusable error. The unemployment and loss of output they are attacking is not the cost of fighting inflation at all — it is the price that must be paid for having inflation.
As for the problem of persistent widespread unemployment, this is caused by maintaining the cost of labour services above their market clearing rates. As the Austrian school of economics points out, so long as there is sufficient land and capital to employ people persistent widespread unemployment9 should not emerge
It needs to be said, however, that in Australia the defence of free labour markets has been handled with incredible incompetence along with a staggering ignorance of economic history.
* * * * *
1Economic Planning Advisory Council Background Paper no. 24. Canberra: AGPS 1992
2Steve Kates asserts that the ‘classical theory’ of the trade cycle shows that booms are unavoidable and spontaneous and are not monetary based. This is the exact opposite of what these economists said. The Real Classical School Theory of the Trade Cycle.
3Richard Cantillon, Essay on the Nature of Commerce in General, Transaction Publishers, 2001. This book should be compulsory reading for every economist.
4For some odd reason many Austrian school economists keep insisting on calling the market rate of interest the “natural rate”: There is no natural rate of interest just as there is no natural price for apples or labour services. The current concept of a natural rate of interest started with Knut Wicksell. It is generally accepted that his “natural rate”— or at least one of them — is defined as the rate at which the demand for capital goods equals the amount of saving expressed in terms of physical goods that are offered in payment. Arthur Marget argued that Wicksell’s “natural rate” had been wrongly translated. He pointed out that Wicksell gave a number of definitions of the “natural rate”. He called the translation
a linguistic accident the consequences of which have been as amazing as, in my opinion, they have been deplorable. The most far-reaching of these consequences has been the identification of the “natural rate” as the rate which would be set if “real capital” lent in natura… [a state of barter]. (Arthur W. Marget, The Theory of Prices, Vol. I, Prentice-Hall, Inc., 1938, pp. 201-204).
I think economists would be well-advised to drop altogether the confusing concept of the “natural rate” of interest.
5Henry Thornton was the first, I believe, to explain that forcing the rate of interest down below the market rate would cause excessive business borrowing. Others soon followed his lead, including David Ricardo. Regardless of what Steve Kates tells people, the consequences of driving down the rate of interest below its market rate was central to the classical theory (correctly called the currency school theory) of the trade cycle. See in particular Thomas Mushet’s work and also Robert Torrens’ scathing take-down of what Kate falsely calls the classical theory.
Henry Thornton, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, 1802, George Allen and Unwin, 1939, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, George Allen and Unwin, 1939, pp. 253-54.
David Ricardo, The High Price of Bullion: A Proof of the Depreciation of Bank Notes, John Murray, Fleet Street, 1811.
Thomas Mushet, Attempt to Explain the Effects of the Issues of the Bank of England Upon its Own Interests, Public Credit, and Country Banks. Baldwin, Craddock, and Joy, Paternoster Row, 1826.
Robert Torrens, Edinburgh Review for January 1858 to April 1858.
6A noted criticism of the Austrian theory of the trade cycle is that the empirical evidence does not support its claim that the boom restricts consumption by over-investing. But the Austrian theory never made such a claim. It focuses on malinvestments, meaning misdirected investment. It does not assume forced savings though it recognises the possibility. As von Mises stated:
It is customary to describe the boom as over-investment. However, additional investment is only possible to the extent that there is an additional supply of capital goods available. As, apart from forced saving, the boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment. The essence of the credit-expansion boom is not overinvestment, but investment in wrong lines, i.e., malinvestment.
Gottfried Haberler is largely responsible for this gross misrepresentation of the Austrian theory. There is absolutely no excuse for Haberler’s error. As for those economists who swallowed his opinion without bothering to study Austrian trade cycle theory, their behaviour is equally inexcusable.
Ludwig von Mises, Human Action, Henry Regenery Company, 1963, p. 559.
Gottfried Haberler, Prosperity and Depression, United Nations, New York, 1946.
7There is a curious view that because business does not always respond to a lowering of interest rates this refutes Austrian theory. But the Austrians are fully aware of the fact that business requires the prospect of profit (Human Action, pp. 555, 584). also Interventionism: An Economic Analysis (1941), The Foundation for Economic Education, Inc. 1998, p. 74.
8This process was vividly explained by classical economists. However, critics argue that the Austrians must be wrong because America had booms and busts before she had a central bank. Once again the critics get it wrong. It is fractional banking that does the damage, which is what the currency school also argued. The reason why Austrians point to the central bank today is because it is supposed to be responsible for the money supply and thus the banking system.
9The unemployed are defined here as those able and willing to work.