Freeman

ARTICLE

Inflation and Unemployment

JUNE 01, 1986 by HANS SENNHOLZ

There are many great truths which we do not question every day; we accept them as a measure of knowledge, translate them into action, and pay homage to them by using them. For centuries economists accepted as truth that man’s income and wealth are strictly limited by his ability to produce. Economists reflected, not about man’s capacity to consume, but about his ability to produce.

Classical economists liked to cite Say’s law named after the French economist, Jean-Baptiste Say (1767- 1832), who taught that economic production itself generates an income equal to the value of goods produced. There is no reason for fearing surpluses and unemployment because supply generates its own demand. And neither supply nor demand were thought of being capable of causing inflation or deflation. Inflation was attributed exclusively to coin debasement and paper money creation by government during periods of war and civil strife. Once peace was restored inflation was expected to come to an end.

In his General Theory of Employment, Interest and Money (1936) John Maynard Keynes rejected this very foundation of Classical economics. He indicted the market order for breeding mass unemployment, and appealed to government for creating conditions of full employment. Demand may fall below supply, which calls for increased government spending, to make up for the lack of demand, or for lower taxes or increases in the stock of money, or a combination of all three.

Keynesian economics postulates a definite relationship between unemployment and inflation. Goods prices remain stable, according to Keynesian theory, as long as there is some unemployment. Inflation raises its head only beyond the full employment mark when demand exceeds supply and no idle resources are available to increase output (demand-pull inflation). The relationship is said to be illustrated by the Phillips curve named after A. W. Phillips, a British economist. As unemployment increases, the rate of inflation decreases; as unemployment decreases, the rate of inflation rises. Conversely, as the rate of inflation is made to fall, unemployment rises; as the rate of inflation rises, unemployment is said to fall. The relationship presents an unfortunate trade- off in which unemployment is the cost of price stability, and inflation the cost of full employment.

There is No Phillips Curve

There is nothing so elastic as the human mind. Lord Keynes and his followers press it and stress it in order to develop intricate trade-offs and other formulas that indict the unhampered market order and call for government intervention. Surely, politicians and government officials the world over can be expected not only to hail Keynesian recipes for government power as the ultimate revelation of economic wisdom, but also proclaim and celebrate its champions as the thought leaders of our age.

Politicians and government officials depend on Keynesian economists to provide the doctrines of governmental function and power; Keynesian economists in turn can rely on politicians and government officials to bestow prestige, position, and income on their intellectual defenders. As so often in human history, the men of power and the official cast of political thought leaders are led to cooperate for the sake of mutual benefit.

The doctrine of an inverse relationship between inflation and unemployment is a crude generalization of fictitious interaction between inflation and unemployment. It denies basic economic principles, obscures economic knowledge, and contradicts economic reality. Many Keynesians themselves are beginning to wonder whether the Phillips curve really exists.

Actually, the curve contradicts economic thought and experience. Economic records clearly reveal that the age of the classical gold standard was an age of unprecedented monetary stability together with full employment. Goods prices in Great Britain were approximately the same in 1914 as they were in 1851, without the evils of chronic unemployment or much cyclical unemployment. Our 19th-century fore-bears worked from dawn to dusk and yet enjoyed stable prices and hard money. There was no inverse relationship between inflation and unemployment; no one charted a Phillips curve.

Also, recent experience casts doubts on the existence of a Phillips-curve relationship. A chart drawn for the 1960s differs substantially from one for the 1970s, which again differs from one for the 1980s. The upward shift in the curves indicates that the “trade-off” varies greatly—that is, for a given inflation or unemployment rate the corresponding unemployment and inflation rate is much higher on later charts. In 1963, 1972, and 1974, the unemployment rate was nearly the same, but the inflation rates were 1.6 per cent, 3.4 per cent and 12.2 per cent respectively. Which one is the Phillips relationship? The chartists cannot answer this question because there is no causal relationship between inflation and unemployment that can be charted in any way or form. There is no Phillips curve in real life.

But even if there were such a curve, it would not explain the relations between inflation and unemployment. The chartist who gathers the data and plots the curves would still need to explain the causal relationship. In particular, he would need to answer the question of why there is a trade-off and why it varies continuously, which contradicts the regularity of the relationship. He fails to provide an answer by adding a distinction between unemployment that is frictional, structural, and cyclical. Frictional unemployment is said to arise from voluntary worker movement between jobs. The unemployment that is called structural and cyclical is said to spring from a mismatch between the supply of and demand for labor, especially when total spending and output fall and the over-all demand for labor declines. The mis-match is to be corrected by governmental intervention of one form or another.

All types of unemployment are said to be subject to the trade-off depicted by the Phillips curve. Most Keynesians are quick to describe and illustrate it; a few try to explain it with vague generalities and references to inflationary forces. During periods of low unemployment when the demand for labor is high, we are told, wage rates are forced up causing goods prices to rise, that is, generating inflation. Conversely, when unemployment rises, wage rates cannot be raised so easily, which causes production costs and goods prices to remain relatively stable.

Such an explanation either fails to explain the relationship or explains it incorrectly. It does not discuss the force that causes wage rates to rise and produce inflation. If there is such a force it needs to be analyzed in all detail so that we may understand it and correct it. Merely to chart it and describe its effects and then recommend a dose of inflation and credit expansion is to escape economic reasoning. It also avoids the important questions of why and how a wage force of any kind can cause all goods prices to rise and inflation to raise its head. Can workers actually bring about inflation that depreciates the monetary unit year after year until nothing is left? Keynesians refuse to answer; in fact, they seek to escape economics by pointing at totally unrelated factors for the changing trade-off, such as a worker’s age and sex.

Why is the unemployment rate corresponding to a given inflation rate much higher today than in the past? We are told there are more women and teenagers in the labor force, experiencing discrimination and suffering more unemployment. Moreover, having experienced more inflation during the 1970s people have come to expect more inflation during the 1980s. The Keynesian thus beats a hasty retreat from the abstract world of economics to the safe ground of psychological and sociological understanding to rejoin politicians and officials for further deliberation on legislation and regulation. He places his trust in political force rather than economic principle.[1]

Deceit Is a False Road

If Keynesians were more receptive to orthodox economic knowledge they would know of the direct relationship between the demand for labor and its cost, between unemployment and gross wage rates. Employment is a function of labor cost and labor productivity. Unemployment always appears when labor cost exceeds labor productivity, creating an excess supply of labor over demand for labor.

Unemployment is a pricing phenomenon as is the surplus of any other economic good. There is no direct relationship between inflation and unemployment. Inflation willfully conducted by monetary authorities causes a rise in the prices of all products and services. If, at times, the rise in labor cost lags behind the rise in product prices, real wage rates decline, which causes the demand for labor to rise and institutional unemployment to fall. This is why Lord Keynes and his followers favor inflation and credit expansion as a suitable method for reducing unemployment. In the Keynesian system workers hopefully do not realize that their wages are reduced and, therefore, in Keynes’ own words, do not resist “a gradual and automatic lowering of real wages as a result of rising prices.”[2]

A government that practices concealment or deceit in matters that should be fair and open as day destroys public confidence and trust. Deceit is a false road to anything, including full employment. It does not work, especially not in such plain matters as the cost of living which every housewife is watching and appraising every day. Workers who are determined not to suffer reductions in their real wages cannot be led to suffer reductions through deceit. In fact, it is easier by far for government to deceive itself without perceiving it, then to deceive the people without their finding it out.

To practice a little deceit, which works only on simpletons and fools, the Keynesians propose to resort to inflation which is one of the worst economic calamities and social evils. Its effects are ominous and calamitous. Inflation benefits politicians, officials and entitlement grantees at the expense of producers, and enriches debtors at the expense of creditors; it creates a massive flow of unearned income and inflicts undeserved losses.

Inflation consumes productive capital, lowers labor productivity and wage rates, and destroys me middle class that saves and invests in monetary instruments. It generates the business cycle, the stop-and-go, boom-and-bust reactions of business. It invites government controls over prices and wages and other restrictive policies. In short, ‘inflation breeds economic evil and social disorder, and generally erodes the moral and social fabric of a free society—and all this for the sake of deceiving some workers.

Economists do not invoke inflation in order to alleviate some unemployment. They go directly to the cause and seek to eradicate it or at least reduce it. Shunning such metaphoric terms borrowed from physics as frictional and structural, they distinguish between voluntary joblessness and institutional unemployment. The former may reflect a voluntary, temporary withdrawal of a worker from the labor market or result from changes in the market process to which he needs to adjust. This kind of unemployment may occur especially in a productive, prosperous society in which the individual may be able to unwind occasionally and take a vacation before he embarks upon new opportunities.

Extraneous Force

Institutional unemployment is involuntary unemployment. Its proviso and requisite is extraneous force that creates an excess of labor over the demand for labor. It is impossible and inconceivable in an unhampered labor market. But it appears wherever extraneous force disrupts the smooth functioning of labor markets. By rendering some labor uneconomical, force makes it unemployable.

In final analysis, government is the only extraneous force that can interfere with the purchase and sale of labor. It does so through labor laws and regulations, taxes, levies, and other exactions; through permits, licenses, and franchises; through deficit spending, inflation, and credit expansion; it may even impose price and wage controls. Politicians prescribe the intervention, judges confirm it, and armed policemen enforce it.

In recent decades governments the world over have delegated some of their coercive powers to labor unions. Labor law and regulation tolerate union violence within broad limits. They permit unions to inflict bodily harm on strikebreakers and employees who engage them, to damage their property, and even injure customers who patronize them. The police rarely interfere with the offenders, public prosecutors do not charge them, and judges do not judge them. In general, government is unwilling to interfere with the actions of labor unions, which grants them coercive powers over large segments of the labor market.[3]

Institutional unemployment may spring from two basic sorts of intervention. Force may be used to raise labor costs above the rates an unhampered market would establish. Or it may be used to lower the productivity of labor through taxation, regulation, and inflation. Both government and unions freely resort to both forms of restraint in countless different ways. Workers who refuse to concede to prompt wage reductions face unemployment.

Most politicians and government officials actually believe that they have the power to raise wage rates and confer fringe benefits. Trusting in the might of the courts and police they mandate minimum wages that exceed unhampered market rates, grant social security benefits and impose numerous other costs that mean to benefit workers. In boom and recession politicians foist themselves upon the labor market, raising the cost of labor by boosting unemployment compensation, liberalizing worker’s compensation, and passing the costs on to em ployers. In many industries fringe benefits now equal or even exceed the cost of payroll. Unfortunately, to force a worker’s cost above the value of his contribution is to render him uneconomical and, therefore, unemployable. Every time government mandates higher labor costs it renders some labor “unproductive” and causes it to be unemployed.

The effects are similar when the productivity of labor declines for any reason and workers refuse to suffer instant reductions in pay. Reduction in labor productivity, after all, raises the unit cost of production in the same way as a mandated boost in cost. It may result from any number of government interventions, union actions, worker attitudes, and even public choices and preferences. It may be inflicted by politicians and government officials who render labor less productive through onerous taxation and myriad regulations. It may be the intentional objective of the workers themselves who, acting in concert as a union, choose to work less and demand more, who impose more work rules that boost costs, or even halt operations by calling a strike. And finally, labor productivity may decline due to changing aspirations, values, and customs on part of the public.

A society that chooses to live beyond its means, that consumes more than it saves and invests and, therefore, reduces the amount of business capital invested per worker, causes labor productivity to decline. Inevitably, it experiences reductions in labor conditions and standards of living and, if wage rates are not permitted to adjust promptly to the decline, is liable to suffer mass unemployment. Unproductive labor tends to be unemployed no matter how it became unproductive.

Inflation Lowers Labor Productivity

Among the many strategems of government intervention that reduce labor productivity and produce unemployment, inflation is one of the most harmful. It is so potent that, in the end, it may play havoc with labor markets, shatter labor productivity, and destroy millions of jobs. Indeed, there is nothing more conducive to unemployment than a policy of willful inflation.

Inflation erodes and consumes capital and hampers its productive employment. It falsities economic calculation and accounting and causes businessmen to make costly mistakes. Inflation permits government to exact more taxes from business, especially by denying inflation adjustments. When businessmen are forced to ignore inflation, to depreciate plant and equipment only on the basis of past cost rather than current cost, they are made to understate production costs, overstate business profits, and pay higher taxes. In fact, they may be forced to show profits where there are none, and pay income taxes without income—even on losses.

Inflation tends to create illusions of income and wealth that tempt people to raise their levels of consumption. When stock and real estate prices soar a feeling of success and prosperity may seize investors and induce them to buy expensive automobiles, build beautiful mansions, patronize the arts, contribute more to charities, or seek more recreation and pleasure. Blinded by soaring prices and deluded by inflation profits, they are actually consuming their capital.

Similarly, employers are likely to yield readily to unionized labor routinely demanding more pay for less work. After all, the income statement supports the illusion of rising profits and growing wealth, and reinforces the expectation that rising prices will soon cover union demands. This management attitude, especially with “professional management” that lacks ownership interests, may explain the fact that wage rates in unionized industries, such as steel and automobiles, exceed by far the rates in open labor markets. When the inflation finally comes to an end, at least temporarily, and a recession settles over commerce and industry, disaster is bound to happen. Unionized industries suffer staggering losses, and millions of faithful union members lose their jobs.

Redirecting Business Capital

Free and open industries cope with inflation more smoothly and efficiently without suffering the pains of crisis and unemployment. When labor productivity declines real wage rates are quickly reduced. Surely, this may be hidden by the veil of inflation that causes all prices to rise. But prices do not rise evenly and simultaneously; wage adjustments tend to limp behind the rise in goods prices, causing real wages to fall. For example, when goods prices rise by ten per cent, wages may be raised by five per cent, which reflects a real pay cut and prompts adjustment to falling labor productivity. Workers suffer reductions in real income, but need not worry about the readjustment crisis and loss of jobs that characterize unionized industries.

Many writers are convinced that a little inflation is beneficial not only to business but also the public at large. They argue that wage rates tend to rise more slowly than goods prices, which shifts income from workers to employers and turns wages into profits. In time, the profits are said to be invested in business capital, bringing improvements to labor productivity and worker income. Unfortunately, economic reality differs materially from this version of inflation theory. The reduction in labor costs may be offset by boosts in capital costs as interest rates are likely to rise; it may be offset by a rise in the cost of material and supply and, last but not least, by new exactions of government. Surely, there are many businessmen who hope to profit from inflation, but very few actually do.

Chronic inflation discourages saving and investing and, in the end, may generate a “flight into real values.” It may cause commerce and industry to redirect their efforts from consumer service and satisfaction to personal survival. Working capital may be turned into gold, silver, or other precious metals; money and claims to money may be exchanged for machinery and equipment that are not needed but hopefully retain their value. Businessmen may invest in land, which may be illiquid and rather unproductive.

Such a redirection of business capital, which may prove to be highly productive for purposes of survival, usually takes the form of withdrawal from production for the market. Or, it may mean redirection of facilities from more efficient uses for which they were meant, to less efficient uses made advisable by the inflation. In every case it lowers labor productivity; in situations of hyperinflation it virtually destroys it. If in such situations the cost of labor is prevented from adjusting to the fall in labor productivity, institutional unemployment is bound to follow.[4]

The productivity of labor may be depressed further by the workers themselves. Undoubtedly, they resent the economic stagnation and decline in income, although they themselves may favor the inflationary policies that prompt the decline; as voters they may cast their votes for politicians who promise yet easier money and credit. Workers may not understand the significance of such policies and their effects on labor productivity and income. Under the influence of popular notions and union dogma, they are quick to ascribe any reduction in pay to employer greed and management incompetence, which does not make for amicable labor relations.

In frustration and anger, some workers may loiter, hold back production, resort to sabotage, or walk off their jobs. Their reaction may be instinctive and understandable; nevertheless, it compounds the fall in labor productivity and aggravates the pains of unemployment. In the end, inflation causes millions of workers to be unemployed, and more millions to be alienated, angrily protesting against the stagnation and deterioration of conditions and marching in picket lines that add to the unemployment lines.

Inflation is a primary cause of unemployment. And yet, learned men and reputable advisers prescribe it, and powerful politicians and officials apply it as a cure for unemployment. In the name of “full employment” they create money and credit that generate the business cycle, misdirect human labor, reduce the productivity of labor, and create mass unemployment.

Inflation is a primeval evil that breeds many other evils. Springing from government power over money and credit and from legal-tender force, it breeds ever more government power that is to alleviate the evil consequences of earlier power. Monopoly power over money conceives the power to inflate, which gives rise to the power to boost wages, grant fringe benefits, reduce labor productivity, and cause unemployment, which in turn reinforces the power to inflate. The consequences lend new strength and support to the cause, in a vicious circle of inflation and unemployment. The circle will end when man rejects all such powers and proclaims his freedom. Man is in the best condition when he is free. []


1.   Cf. Lewis C. Solmon, Economics, 3rd ed. (Reading, Mass.: Addison-Wesley Publishing Co., 1980), p. 323 et seq.

2.   John Maynard Keynes, The General Theory of Employment, Interest and Money (New York: Harcourt, Brace and Co., 1936), p. 264.

3.   W. H. Hurt. The Strike-Threat System (New Rochelle. N.Y.: Arlington House. 1973), p. 252 et seq; Patrick M. Boarman. Union Monopolies and Antitrust Restraints (Washington, D.C.: Labor Policy Association. 1963). p. 64 et seq; Edwin Vieira. Jr.. Of Syndicalism. Slavery and the Thirteenth Amendment (reprinted from The Wake Forest Law Review, Vol. 12, No. 3, Fall 1976).

4.   Hans F. Sennholz. Age of Inflation (Belmont, Mass.: Western Islands. 1979), pp. 33-39.

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