All Commentary
Wednesday, February 22, 2012

How Government Distorts Labor Markets

In a recent post at the ThinkMarkets blog, Freeman author Gerald P. O’Driscoll cited Union Pacific Railroad’s labor woes as an example of the mismatch between the skills workers possess and the skills potential employers are seeking. O’Driscoll argues that there has been an unsustainable boom in “human capital” characterized by massive malinvestments, just as Austrian economists typically claim for physical capital goods. This perspective is a useful antidote to the Keynesian analysis of our current slump and leads to radically different policy recommendations.

O’Driscoll based his post on a Wall Street Journal report that referred to “survey results showing that 83 percent of manufacturers reported a moderate or severe shortage of skilled production workers. . . . Wages for skilled labor are rising, in some cases at double-digit rates.”

He noted: “Malinvestment in labor markets is the counterpart to malinvestment in capital goods. Higher education is a bubble, and colleges churn out graduates with degrees that have no application in the workplace. Student borrowing to acquire such degrees is malinvestment in the same way that construction loans to build homes in Las Vegas was malinvestment.”

And here is his policy conclusion: “There is no mechanism by which lowering interest rates (‘monetary stimulus’) or spending money on public workers (‘fiscal stimulus’) is going to cure the problem. Labor mismatch is a manifestation of a coordination failure. . . . It is a microeconomic problem.”

O’Driscoll’s remarks underscore the stark theoretical contrast between today’s Keynesians and Hayekians as they approach “macro” problems, notwithstanding recent claims by Paul Krugman and others that Hayek’s contributions to the field were insignificant.

Today’s economic problems do not emanate primarily from a shortfall in aggregate spending but rather from a poor synchronization among all the millions of individual productive inputs (including labor) that typically interact seamlessly to support our fantastic standard of living. Once we recognize this as the fundamental problem, the standard Keynesian medicine turns out to be not merely a placebo but a poison.

In the traditional exposition by Ludwig von Mises and F. A. Hayek, the Austrian theory of the business cycle explains recessions as the inevitable consequence of a preceding inflationary boom. The boom occurs when the commercial banks (nowadays acting in concert with the central bank) issue new loans even though the public isn’t saving more, thereby increasing the quantity of money and driving the interest rate below its “natural” level. The lower interest rates—“cheap money”—foster a feeling of euphoria, as businesses invest more and households consume more.

The Austrians argue that the boom is illusory because the banks can’t create genuine resources simply by extending loans on their balance sheets. If the economy had previously been in a sustainable equilibrium, it will now be “growing” on an unsustainable trajectory.

When mainstream economists hear the Mises-Hayek explanation of the boom-bust cycle, they often characterize it as an “overinvestment theory.” Yet Mises himself took pains in Human Action (chapter 20) to clarify that this wasn’t the case:

 The erroneous belief that the essential feature of the boom is overinvestment and not malinvestment is due to the habit of judging conditions merely according to what is perceptible and tangible. The observer notices only the malinvestments which are visible and fails to recognize that these establishments are malinvestments only because of the fact that other plants—those required for the production of the complementary factors of production and those required for the production of consumers’ goods more urgently demanded by the public—are lacking.

Mises goes on to make his famous analogy, which remains the best metaphor yet for his theory:

 The whole entrepreneurial class is, as it were, in the position of a master builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master builder’s fault was not overinvestment, but an inappropriate employment of the means at his disposal.

In a standard neoclassical growth model we could meaningfully speak of “overinvestment” leading to suboptimal results. Specifically, if people for some reason (perhaps because they were cajoled by government policies) save a higher fraction of their income than they would have chosen in a neutral setting, then capital goods will accumulate at a faster rate, and gross domestic product (GDP) will grow at a faster rate.

However, this outcome is a bad thing—as judged by the real preferences of the households in the model—because the higher investment and faster growth are achieved at too high a price in forfeited consumption in the present and near future. If an eccentric gangster has a standing threat to blow up a family-owned business unless it reinvests 99 percent of the profits for ten years straight, on paper the business may actually prosper, but the family members are clearly harmed by the arrangement.

Yet this type of overinvestment isn’t at all what Mises and Hayek have in mind when discussing the unsustainable boom. As the quotations from Mises illustrate, the fundamental problem is not that society (during a boom) leans too heavily to the left side of the investment/consumption spectrum. Rather the problem is that the investments are not in sustainable lines.

The Wrong Tools

To give an exaggerated example, mainstream economists—by classifying the Austrian theory as one of “overinvestment”—have in mind that businesses produce too many tools and not enough pizzas. Yet this type of mistake wouldn’t require a recession; it would simply mean that consumers would be trading off present enjoyments (which they valued more, by stipulation) for a higher income in the future made possible by the productivity-enhancing tools.

Rather than being about making too many tools and not enough pizzas, the Austrian story is more about businesses producing tools consisting only of thousands of screwdrivers and millions of nails. For a short while, especially if we just focused on a few of the factories, such an absurd economy would seem very “productive” indeed, poised on the verge of explosive growth. But from a systemwide perspective it is obvious this economy would soon collapse once its existing tools wore out and workers had to rely on the new batch. When the crisis occurred it would be wrong to characterize the problem as one of “too much investment in tools.” The fundamental problem would be malinvestments in the composition of the stock of new tools.

Idle Resources

Because they lack the Austrian emphasis on the structure of production, Keynesian economists look at idle resources, or “excess capacity,” during a recession and see pure waste. Of course the market economy is malfunctioning if factories are running below capacity and especially if workers are sitting at home watching TV. This is why (the Keynesians claim) a recession calls for expansionary fiscal and monetary policies to increase aggregate spending and put those resources back to work.

This simple-minded view is dead wrong in light of the Austrian explanation. Continue with Mises’s master builder, who embarks on construction of a house using blueprints that rely on an erroneous brick count. When the builder discovers his error—he realizes he only had 18,000 bricks in the beginning instead of the 20,000 called for by the blueprints—what will be his immediate reaction? He will yell, “Everybody stop working!”

The reason for this immediate stop order is clear. If every worker continued in what he had been doing, the dwindling stocks of various resources (bricks, shingles, nails, window panes, and so on) would have been transformed into less “liquid” items. The builder obviously has to adjust the blueprints in light of the new information; it is physically impossible to complete the house as originally conceived. Therefore he needs to halt all activity until he decides the best way to deploy the remaining inputs, all things considered.


Eventually more and more of the workers can gradually resume activity, but many of them won’t be doing exactly what they were doing before, and some of them might be doing very different tasks. Also, some of the workers who were highly specialized might not be needed at all for the remainder of the project. It made sense for them to show up at the site based on the original blueprints, but after the necessary revisions the master builder realizes these particular workers serve no role.

The analogy with a modern economy should be clear. When an unsustainable boom collapses there is an initial surge in unemployment of both human and physical resources. Gradually—especially if the government leaves the market process to operate freely—more and more resources are reintegrated into the (revamped) structure of production. The process unfortunately might be agonizingly slow for some resources and workers with highly specialized skills.

Notwithstanding the tragedy of high unemployment, it is a necessary consequence of a preceding inflationary boom. Austrians stress that the boom is the problem; the bust is ironically the cure. Like many types of medicine, recessions are not nearly as enjoyable as the activities that brought on the calamity.

Considerations such as these led O’Driscoll to describe our current economic woes as “microeconomic.” Think again of the master-builder analogy. Before the discovery of his mistaken brick count the problem wasn’t that the builder was “building too aggressively.” It was that he was building a house with the wrong proportions. Then, after the discovery of his mistake, the problem wasn’t that the builder was “building too timidly.” Instead, the problem—if we want to call it that—was that the remaining stocks of usable resources were ill-suited to complete the half-finished house.

In the master-builder metaphor the analog of expansionary policies would be to reassure the builder that his brick count is accurate after all. For example, a subordinate might not want the workers to “lose morale” and so he might keep moving tarps around, covering up the dwindling brick supply and lying to the master builder about how many remain. This would keep the “good times” rolling, at least for a while. Yet it will just make the crisis that much worse when it finally arrives, as it must. Moving tarps around can’t create more bricks, just as moving bad loans around with TARP can’t create more physical resources.

We’ve seen that even the canonical exposition of Austrian business cycle theory involved labor, as it must if it is to explain high unemployment. However, the typical Mises/Hayek story focused on malinvestments in physical capital goods, which eventually led to high unemployment in the labor market. The twist O’Driscoll gives is that the original malinvestments during the boom period might themselves be in “human capital.”

Boom Builders

Some of this malinvestment can be tied directly to the housing boom. Just as too many nails and shingles went to Las Vegas and Miami from 2002–06, so did too many human beings move to these cities and spend years developing skills in home construction. When the housing bubble popped, the nails and shingles had been irrevocably devoted to houses that never should have been built, while hundreds of thousands of workers had a difficult-to-modify skill set that never should have been learned.

There was a similar toll in financial services. During the giddy years top-flight students with an aptitude in mathematics were drawn out of physics and other scientific fields and flocked to Wall Street to become rich as “quants.” In retrospect we now realize that some of the brightest minds on the planet had literally spent years working grueling schedules to (in effect) devise various techniques to amplify the financial fallout from an economic downturn. This was hardly an optimal use of scarce labor.

As O’Driscoll notes, even higher education itself can be viewed as an unsustainable bubble in light of Austrian theory. The false prosperity of the boom years led to large increases in education budgets, fostering erroneous expectations of how many jobs would be available for future Ph.D.s in the “soft sciences” and other fields that do not have a market outside academia.

The Austrian theory of the business cycle shows how monetary disturbances can lead to “real” imbalances in the structure of production. The classical version of the theory focused on malinvestments in physical capital goods, but the theory can easily be amended to include the unsustainable development of human capital. In either case the best government response is to eliminate the subsidies, low-interest loans, and other policies that encourage the very problems under consideration.

  • Robert P. Murphy is senior economist at the Independent Energy Institute, a research assistant professor with the Free Market Institute at Texas Tech University, and a Research Fellow at the Independent Institute.