Why Unemployment Persists: Part I

(Geoffrey Lawrence/NPRI) – Pundits and policymakers are easily perplexed by economic recessions and their most visible manifestation, unemployed workers. To these commentators, it is mysterious that labor unemployment remains high across the nation despite massive federal deficit-spending policies, financial bailouts and monetary easing. Here in Nevada, the official unemployment rate has remained in double digits for 29 straight months.

Befuddled, many prominent commentators grasp at straws to explain causes of the suffering. Some blame inadequate spending on education, health care or economic development. These claims fail to acknowledge the wealth destruction that would accompany the higher tax rates necessary to finance such increased government spending. The claims further ignore that state spending in the areas of K-12 education, health care and economic development has long been increasing exponentially.

What these misdirected pundits and policymakers most sorely need is a solid grounding in economics. They then would understand that systemic labor unemployment is not a mysterious or mystical phenomenon loosely attributable to any of a litany of potential causes that may bear, at best, some secondary relationship. In reality, the systemic labor unemployment associated with economic recessions has little to do with the labor market at all. Instead, it is the result of a misalignment in society’s capital structure.

As Ludwig von Mises, Murray Rothbard and others have explained, capital is the result of individuals’ decisions to store up their labor productivity in the form of savings, rather than to consume it immediately. This “stored” labor can be used to immediately construct tools, machinery or processes that will help individuals produce even more efficiently in the future. Or it can take the form of monetary savings — allowing individuals to purchase the capital goods (i.e., the tools, machinery or processes) they seek.

For example, a farmer selling wheat might elect to save 20 percent of his income so that he can eventually purchase a tractor to replace his hand plow. Alternatively, the farmer can use the savings of others by purchasing it on capital markets. The price he pays for the use of others’ savings — the interest rate — is determined by the total supply of, and demand for savings on the market. This reflects individuals’ combined preference for delayed versus present consumption.

Once he obtains the tractor, the farmer can dramatically increase his yield, to the benefit of himself as well as his customers — who will enjoy a greater supply and, consequently, lower prices.

Thus, Mises astutely observed that capital accumulation is the key to improving living standards. He also recognized the corollary truth: that the assurance of private property rights is requisite for individuals to invest and plan long-term rather than to immediately consume what they produce. As he once wrote, “It is fashionable nowadays to pass over in silence the fact that all economic betterment depends on saving and the accumulation of capital. None of the marvelous achievements of science and technology could have been practically utilized if the capital required had not previously been made available.”

So, how then, can capital accumulation — the driver of “all economic betterment” — result in that dreaded situation known as systemic labor unemployment?

The answer is, it doesn’t. However, falsified signals of the existing level of capital accumulation do exist — produced by artificial expansions of credit — and they distort both the quantity and quality of capital investment.

In the United States, the two major sources of artificial credit expansion are the Federal Reserve, which creates new money in order to manipulate economy-wide interest rates, and the banking industry, which expands the monetary base by repeatedly lending against borrowed funds within the Fed’s fractional-reserve system.

Per Rothbard, the expansion of artificial credit gives the appearance that more savings are available than is the case. As a result, entrepreneurs rush to borrow these illusory savings and invest in capital goods. Since the savings rate is implicitly overstated, however, these investments are made based on misinformation. While the Fed and banks can create the illusion that savings are plentiful, they can’t change the reality that what actually prevails is a general preference for more immediate consumption.

The misinformation embodied in credit rates prompts overinvestment in capital goods — lengthening and expanding production processes beyond what consumers actually demand and out of line with market fundamentals. The quality of investments also deteriorates as a result of the misinformation as well, since the requisite discipline over capital allocation is absent when the presumed supply is overstated. As borrowers rush to acquire the new credit, those who apply first are likely to receive a proportion of capital not justified by actual consumer demand, spurring “bubble” industries such as the late-1990s’ Internet frenzy or the Southern Nevada construction mania of the mid-2000s.

So long as banks and the Fed continue expanding credit, the distortions grow more and more pronounced. But as the distortions grow, it becomes more and more clear, to more and more individuals, that the capital structure is seriously out of sync with the actual structure of demand.

As that understanding spreads, investors change their behavior. When major bubbles of complacency and misunderstanding are punctured suddenly, as we’ve seen recently, financial panic ensues and systemic unemployment results — as the realization spreads that far too many workers are employed in the production of higher-order capital goods like Southern Nevada real estate development or heavy machinery in Michigan.

Restoring genuine full employment will require that society’s capital structure actually reflect genuine market demand. But that will require ending the artificial and ultimately destructive credit machinations of the Federal Reserve and the banking industry.

Then workers will depart the “bubble” industries that repeatedly prove themselves unviable — moving instead toward those that more accurately reflect consumer demand.