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Unemployment, recession and inflation
Gerard Jackson
It has been observed that each major post-war Australian recession has tended to be deeper and longer than its predecessor with each succeeding depression accompanied by a higher level of unemployment. So mystifying is this phenomenon to Australian economists that it is almost dismissed as an act of God.
For example, in A Defence of Economic Rationalism (a book of essays defending the market) there is not the slightest recognition of what causes this peculiar situation. In one essay Michael Warby (formerly with the Institute of Public Affairs) acknowledges the phenomenon and then quickly leaves it behind as one would an embarrassing situation.
The failure to understand the forces that result in succeeding depressions being accompanied by higher levels of unemployment is due to the acceptance of two economic fallacies: treating money as neutral and capital as homogeneous. If money is neutral then changes in money supply can only affect output and the price level. Hence changes in the money supply cannot misdirect production thus creating malinvestments. It also follows that if capital is homogeneous (meaning that all capital goods are perfect substitutes for each other) bottlenecks cannot occur and capital cannot be lost through malinvestments.
However, money is not neutral and capital is a heterogeneous structure. The social, political and economic ramifications of these two facts are enormous. That they are not recognised, let alone understood, by the vast majority of economists makes one realise just how inadequate neoclassical economics really is, especially in regard to capital. Because capital is a heterogeneous structure, investments must be synchronised, they must, so to speak, mesh.
When a capitalist embarks upon a project it is always in the expectation that the other stages of production, without which his project cannot succeed, will be completed so that his own project fits into the capital structure. It is the coordinating function of the unhampered market that makes this capital synchronisation possible.
The non-neutrality of money becomes of crucial importance when we realise that when it enters the economy it must do so at a particular points. It is at these points that the misdirection of production begins. This is usually done by lowering the rate of interest below the market rate. Projects that were unprofitable at the market rate of interest are now financially viable. When business borrows to invest in these projects it bids capital goods away from other lines of production which raises their prices.
Now it is true that all goods have to be bid for, that every project competes with every other project for resources. But what must be kept in mind is that the market rate of interest performs the equilibrating function of bringing the supply of capital goods into balance with the demand for capital goods. By artificially lowering the rate of interest, business has been told that there is more capital (savings) available than actually exist.
This means that business will now engage in projects that cannot be completed because there is insufficient capital. As businesses compete against each other for increasingly scarce capital goods, their costs start rising, bottlenecks emerge, interest rates rise and finally, strangely to most, unemployment starts rising. We have now got the phenomenon of stagflation.
It needs to be explained that general unemployment rises in this situation because either the money supply has been slowed by the central bank or its present expansion is unable to raise prices fast enough to cover costs of production
Obviously, the only way for firms to continue producing is for the prices of their products to rise faster than their costs. So when rising costs start squeezing profits the cry goes up for lower interest rates and easier credit. But this entails even more credit expansion which means accelerating inflation.
In short, these projects have been created by inflation and their existence can only be prolonged by accelerating inflation. Eventually, whether it be rising prices, the current account deficit or a speculative frenzy that forces it to act, the government applies the monetary brakes and the economy crashes. Malinvestments now reveal themselves as unemployed labour and capital. (The actual theory is more complicated than this).
Once the depression (the adjustment period, as the Austrians call it) is in motion, the government should stand aside and allow the necessary liquidations to proceed. However, under the influence of Keynesianism governments now interfere with the adjustment process by reinflating. This has the twofold effect of temporarily rescuing old malinvestments while creating new ones.
The result is that each depression has tended to become deeper, more prolonged and with a higher level of unemployment. Nevertheless, if the depression is allowed to work itself out full employment will be restored, provided that wage-fixing arrangements are not enforced. That, unfortunately, is the tragic case in Australia. Our prolonged unemployment is not the result of the depression but of union-backed central wage-fixing arrangements.
That this explanation (or any explanation for that matter) of the phenomenon of increased unemployment with each succeeding depression should be absent from the likes of A Defence of Economic Rationalism is a startling revelation of just how narrow economic thinking is in Australia.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 5 September 2005