Freeman

ARTICLE

Cyclical Unemployment

APRIL 01, 1986 by HANS SENNHOLZ

Dr. Sennholz heads the Department of Economies at Grove City College in Pennsylvania. He is a noted writer and lecturer on economic, political, and monetary affairs. His most recent book is Money and Freedom.

In the final analysis, government is solely responsible for the business cycle and the unemployment that results.

Employment is an essential source of happiness and enjoyment. No man, properly occupied, can be miserable for long. To enjoy life, man must employ life, which ought to be his aim and aspiration. To be unemployed is to waste life and invite evil. And yet, millions of people who would like to be employed in the market for goods and services, are sporadically unemployed. They are the primary victims of business cycles.

Economic instability has been the lot of man since the beginning of time. Whether he made his living by hunting or fishing, by cultivating the land, or engaging in industry, commerce or finance, man always faced the vicissitudes of economic life. There were good times and bad times, but these changes were caused by such extraneous influences as crop failures, epidemics, civil strife, or war. Business cycles are modern phenomena—products of the modern economic order with its political conditions and institutions. The first business cycles in the modern sense were recorded in England during the second half of the eighteenth century. The first American depression is known to have taken place in 1819. In many parts of Europe, cycles did not appear until the middle of the nineteenth century, in Russia and Japan not until the end of the century.

Business cycles are visible changes that take place in business conditions over periods of time. Boom conditions are followed by spectacular crises and painful readjustments commonly called depressions. During the course of a cycle the factors of production are subjected to radical changes in demand; they may work overtime during the boom phase and be idle during the crisis. They may enjoy rising prices and incomes during the boom, and suffer staggering losses in the depression. Labor may reap rising wages and benefits during the boom and face unemployment during the depression.

Observers of the economic enigma readily offer their explanations. One group attributes the cycle chiefly to other than economic occurrences such as political incidents, to conflicts and wars, or to changes in the growth rate of population or international and intranational migration. Economists are quick to discard such “outside factors” because they are not inherent to the economic process.

Some economists attribute business cycles to accidental combinations of unfavorable economic circumstances. They are convinced that each depression has its own particular origins such as inadequacy in the stock of money, hoarding and scarcity of credit, over-investment in industry, new technology or real estate. “Practically every economic fluctuation,” Joseph A. Schumpeter explained, “must be a historic individual and cannot be made amenable to explanation but by minute historical analysis of the innumerable factors actually at work in each case.”[1]

Most students of the business cycle question the accidental-com-binations theory. They are convinced that a single cause affects the economic system and generates the cyclical fluctuations. But they differ widely on the nature of the cause. The different explanations offered by distinct schools of thought may be classified according to the causative factors they emphasize:

I.       The complexities of division of labor

      II.       The capitalistic system

      III.       Government intervention

The Complexities of Division of Labor

Many economists point at an “anarchy of production” resulting from the division of the production process as the cause of crises and the unemployment they engender. It is difficult, they assert, for businessmen with limited knowledge of the demand for their products to maintain equilibrium. Entrepreneurs and capitalists face great uncertainties that spring from the roundaboutness of time-consuming processes of production. Moreover, economic goods are produced to be exchanged, which invites errors of judgment that tend to develop cumulatively either toward optimism or pessimism.

A.C. Pigou, reflecting on the economic stagnation of the early 1920s, explained that two businessmen make “at the same time now an exaggerated, now an inadequate estimate of the other’s prospective real demand for his stuff. No study of trade cycles can be adequate in which this point is misunderstood.”[2] Professor Taussig, the foremost American economist of his time, pointed at different stages in the production process that invite errors in entrepreneurial judgment leading to overproduction. “There is overproduction, stoppage, and shutdown, reaction in turn on the making of plant and materials, cessation in the industries which will produce these, and general depression. The recurrence of commercial crises in this way is to be ascribed in the main to overproduction.”[3]

More than 200 years ago Adam Smith viewed man’s division of labor as the most beneficial factor of economic improvement. In the very first sentence of The Wealth of Nations Smith rejoiced about the division of labor. “The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is anywhere directed, or applied, seem to have been the effects of the division of labour.” In contrast to Smith, many modern writers are alarmed about the complexities and difficulties of finance and management that spring from the division of labor. At a loss for an explanation of depression and unemployment, they point at the separation of work into many different component operations through specialization. But no one concludes that man should return to less specialization, which would mean lower labor productivity and lower wage rates.

If improvements in the division of labor actually caused depression and unemployment, the business cycle in the most productive countries, with the most advanced division of labor, would have to be most severe and painful. Feverish booms would be followed by deep depressions. Americans would be affected more severely than Mexicans and Bolivians. in reality, depressions and unemployment are worse by far in Mexico and Bolivia than in the U.S. This is because the follies of government intervention are generally greater in Mexico and Bolivia than in the U.S.

If improvements in the division of labor actually caused depressions, business cycles should have grown worse in recent decades that witnessed world-wide improvements in the division of labor. In reality, recent recessions were demonstrably milder than the Great Depression of the 1930s. Moreover, every improvement in technology, every new instrument of production, which are the fruits of the division of labor, should usher in a new depression and mass unemployment. Every improvement in American computer technology, for example, should breed another cycle. It is obvious that economic reality differs from such conjectures.

To point at “overproduction” as a cause of business cycles is to ignore the unlimited needs and wants of most individuals. While millions of people are starving and thousands are perishing from hunger and want, it is insensible to speak of overproduction. Of course, it is understandable that the socialistic world that is chronically lingering in poverty and despair likes to point at capitalistic countries and charge them with “overproduction.”

The Capitalistic System

Many writers in search of an explanation of the business cycle limit their indictment to the capitalistic system that permits private ownership of the means of production. One group finds fault with capitalistic modes of income distribution; another group centers its attention on the capitalistic process of production.

The capitalistic mode of distribution allocates to every participant the market value of his contribution to production: the businessman his profit, the investor his interest, the manager his salary, and the worker his wage. Some earn high incomes because they make great contributions to the economic well-being of their fellowmen; others earn little because they contribute little. The critics generally prefer a more equal distribution of income and wealth which, in their belief, would assure economic stability and full employment.

Lord Lauderdale (1759-1839) first pointed to consumption as the decisive factor for the quantity of labor that can be employed. “Forced parsimony” reduces the funds allotted to consumption and employment of labor.[4] Similarly, Thomas Robert Malthus (1766-1834) warned against the over-accumulation of capital. A more equal distribution of wealth would alleviate economic stagnation and decline. He favored public works as a means of employment and relief for the working classes: “. . . to assist the working classes in a period like the present, it is desirable to employ them in unproductive labors, or at least in labor, the results of which do not come for sale into the market, such as roads and public works.”[5]

The business cycle theory of Lauderdale and Malthus, faulting the manner in which income is distributed, evoked answers by Jean Baptiste Say, David Ricardo and John Stuart Mill. They developed the so-called law of markets, which in essence denies that business cycles spring from “over-accumulation” and the manner in which income is distributed. By the end of the nineteenth century they reigned supreme in the economic world, which caused the critics to shift from the side of distribution to the side of production. The material conditions in the modern capitalistic order, in particular the roundabout methods of production, now came under attack for causing the business cycle.

Karl Marx in the main echoed the Lauderdale-Malthus explanation, but the thrust of his argument was “exploitation” rather than accumulation and inequality of incomes• Business crises are periodic climaxes of the conflicts inherent in the capitalistic system. Conflicts arise from the accumulation of capital and the growing proportion of fixed capital, which causes a decline in the consuming power of workers. The capitalists “exploit” labor and apply their ill-gotten gains, which they call “savings,” to increase production. In short, they destroy their own markets by reducing “wage capital,” the consuming power of laborers. Depressions temporarily restore the equilibrium between production and consumption.

Marx managed to present yet another explanation for business crises based on the life cycle of business capital. Because capitalists invest in spurts and bursts for various periods of time, “business undergoes successive periods of depression, medium activity, precipitancy, crisis. . . . A crisis always forms a starting point of large new investments.”[6] In short, businessmen not only exploit their workers but also invest erratically and capriciously, which adds instability to exploitation. Their notorious behavior inevitably causes depression and unemployment.

A century after Marx, his countless followers throughout the world continue to explain business cycles as characteristics of capitalism• Total consumption, they propound as revealed truth, lags behind total production because of labor exploitation, which is robbery. Wherever Marxians come to power they summarily abolish private property in the means of production. Wherever they lack political power they openly advocate its abolition.

Throughout the free world the Marxian explanation contends against other explanations, the most popular of which is that of John Maynard Keynes (1883-1946). This British economist was to become the economic patriarch of the free world. The foundation of the Keynesian structure is the Malthusian concept of effective demand which Keynes defines as “the aggregate income (or proceeds) which the entrepreneurs expect to receive . . . from the amount of current employment which they decide to give.”[7] Professor Keynes made consumption the primary element of his economic order. Consumption limits production, not the other way around as the Classical economists had seen it. The “propensity to consume” becomes a basic independent vari able. It brings into existence both production and capital as factors of production. Consumption, along with investment, is the basis of “effective demand.”

Conceived during the Great Depression and resting on the idea of secular stagnation, Keynes’ theory is a scheme of escape from depression by way of a planned or managed economy and socialized demand. The Classical economists built on the assumption of harmony or similarity of interests. In the footsteps of Karl Marx, Professor Keynes built on disharmony and conflict. The interests of savers and investors do not match, which in turn clash with the interests of consumers. Private capitalists are apt to be greedy exploiters or inefficient bunglers, or both, and do not require the rich rewards they usually pocket. To restore and maintain more desirable economic conditions, Professor Keynes recommended central control by politicians and officials. He called upon the state for protection from foreign competition and internal regulation to assure “equitable distribution of wealth and income” and “full employment.”

Keynesian doctrines came to exercise great effect upon government policies throughout the world. The doctrines were not new; there were no new elements in the system, and no new proposals of policy. But the combination of elements, policies, and terminology was new. J.M. Keynes rebuilt an old machine and made it look new. And yet, despite its new appearance it was akin to the appointments of eighteenth century Mercantilists and Physiocrats, and related to the thought which the Classical economists meant to expose and explode.

Thus, most contemporary writers point at one or several features of the capitalistic order as the disturbing factors that are said to upset the economic equilibrium and thus create the business cycle. While they engage in heated debates about the particular feature or features that presumably cause the evil, they leave no doubt that the private property order is ever breeding instability and unemployment. This is why they are demanding that government, the political apparatus of coercion, remedy the stated defects or abolish the system.

Government Intervention

Only a few members of the Austrian school, in particular Ludwig von Mises and other writers in his footsteps, have drawn the extraordinary conclusion that, in the final analysis, government, as the creator of the monetary order and the monopolist of legal-tender currency, is solely responsible for the cycle. These economists deplore all notions and doctrines that place politicians and government officials in charge of the people’s money and cause them to print ever more for the sake of economic “growth” and full employment. In the judgment of these economists, the people must be liberated from the money monopoly and all politicians be banned from monetary matters.

In his explanation of the business cycle Professor von Mises combined given knowledge with new insights. He built on the Ricardian analysis of the effects of currency and credit expansion, on B6hm-Bawerk’s theory of capital and interest, and on Wicksell’s explanation of the potential gap between the “natural” rate of interest and the hampered market rate. Mises concluded that central banks tend to orchestrate processes of money and credit expansion that falsify interest rates. They create and emit new funds which lower interest rates and thereby entice businessmen to embark upon expansion and modernization. A feverish boom is created; wages and other business costs tend to rise.[8]

Drawing on the monetary theory of Mises, his teacher, Friedrich A. Hayek developed a theory that explains how monetary disruption alters relative prices by falsifying interest rates and the pattern of investment. The creation of money and credit generates a new source of demand of goods and resources to which business will react. At first, it generates a shift of spending in favor of future rather than current consumption. That is, it kindles an “investment boom” with rising employment by attracting resources that otherwise would have been consumed. The resources will remain so employed as long as the creation of money continues, it must be continued at accelerating rates in order to maintain the boom employment. If it is discontinued for fear of run-away price inflation, a readjustment commences in the form of depression. If, on the other hand, the monetary expansion continues at accelerating rates, it must ultimately lead to the breakdown of order and production, to disintegration of the division of labor and mass unemployment. A government that, for any reason, embarks upon such policies, holds a tiger by the tail that in the end will devour its keeper.[9]

The Austrian View

Austrian economists see eye to eye about the cyclical movements of economic activity. They agree that employment moves strongly with the basic changes in activity but typically is slower than other features of the cycle. In reaction to declining interest rates, activities preparatory to investment expenditure lead the way—such as incorporations, corporate appropriations for capital expenditures, issuance of building permits, contracts for construction, orders for machinery and equipment, rising commercial debt, and new equity issues. Employment together with general output and consumer prices are slower to react to the new situation. The reason is obvious: it is less onerous and exacting financially to seek a building permit or secure a line of bank credit than to engage and train human labor. Moreover, the building permit may be allowed to expire, the bank credit may remain unused, the equipment order may be shelved, but human labor cannot, with good conscience, be readily hired and then dismissed.

Labor costs per unit of output tend to lag behind other cycle phenomena. Labor contracts usually extend over lengthy periods Of time, which keep total labor costs relatively constant but impose great variations in unit costs depending on the level of output. During the early boom when unit costs fall, the demand for labor tends to rise and wage rates and fringe benefits follow suit. When, later in the cycle, business activity slows down and unit labor costs soar, it is rather difficult to reduce wage rates and fringe benefits. Labor contracts may impose long- term commitments; but even if they do not, it is more difficult psychologically and more troublesome to labor relations to reduce wage rates and moderate labor conditions than simply dismiss labor. It is simpler to dismiss a worker than to reduce his wage rate because he can readily understand and accept unemployment, without lasting damage to his self-esteem, being dismissed for reasons of “lack of work”; it is more difficult by far to accept wage reductions because of “rising unit costs.” Unemployment due to “lack of work” obviously places the responsibility on some mysterious factors over which the unemployed worker has no influence. But to be unemployed for reasons of “excessive labor costs” allocates some responsibility not only to the monetary authorities generating the cycle but also to the unemployed themselves who may have contributed to the boost in costs and then refuse to suffer wage and benefit reductions.

Fluctuations in the number of employed workers are larger in capital goods and commodity-producing industries than in the service trades. After all, the cyclical fluctuations originate in the capital-goods and commodity-producing industries that readily respond to the currency and credit expansion. Businessmen embark upon construction that exhilarates all industries catering to business, that is, tools and dies, computers, steel, copper, lumber, and the like. It also explains why these industries are the first to suffer the fevers and chills of the business cycle. Moreover, the decision to expand or modernize a business is always entrepreneurial; it rests on the perception of the future which is uncertain. Businessmen are quick to change their construction orders when their outlook changes.

Wage disbursements fluctuate within a wider range than salary payments, In business usage, salary refers to a fixed monthly rate of pay, wage to an hourly rate. It is difficult for psychological reasons to reduce any rate of pay when business conditions deteriorate and labor productivity declines. But when labor costs must be reduced because business survival is at stake, employers are likely to begin their layoffs with hourly labor. In most cases this is unskilled or semi-skilled labor and requires very little training. It can be replaced readily and recalled easily without much training expense. On the other hand, employers generally are reluctant to dismiss salaried personnel, which is skilled labor, requiring lengthy schooling, training or apprenticeship before it can be employed productively. Moreover, generous employment compensation paid to unskilled labor tends to immobilize it, keeping it at company gates and waiting to be recalled. Unemployment compensation for skilled or professional labor loses its paralyzing effects when it becomes insignificant relative to the income that can be earned elsewhere. Skilled labor is quick to move on in search of other employment as soon as it is laid off, which makes employers rather reluctant to release it even temporarily.

A Common Cause

This sketch of the nature of business cycles rests on the common cause of all cycles: the money and credit expansion. Government, or its monetary authorities, may conduct it willfully and purposely in order to pursue some other objective, such as full employment, economic redistribution, or its own power and growth. Or, government may monopolize the issue of legal tender money and impose an institutional setting that is bound to disrupt the economic order. American history discloses no cycle that did not spring from this common cause. All depressions had their beginning in a boom that was bred intentionally or inadvertently by government intervention. The political powers to be who brought forth the first depression of 1819 also begot the depressions of 1839-1843, 1873-1879, 1895-1897, 1920-1921, 1929-1938, 1949~1950, 1953-1954, 1957-1958, 1960-1961, 1966-1968, 1973-1975, 19814983. The unemployment that accompanied these depressions must be charged to the same political powers.

Some business cycles were merely disruptions of domestic activity; others encompassed trade and commerce throughout the world. The depression of 1920-1921 attained international scope; the depression of the 1930s assumed catastrophic proportions around the globe. Under the influence of like beliefs and doctrines, governments the world over conducted similar policies that bore similar fruit. Moreover, international interdependence and division of labor cause business cycles to spread from country to country. In small countries, especially, foreign trade and commerce may comprise the lion’s share of economic activity, and foreign conditions may have a decisive influence on domestic matters. Foreign exports and imports, world commodity prices and interest rates usually play a vital role in the process of cycle transmission.

in recent years business cycles have become global disruptions that emanate from the U.S. In 1971, under U.S. leadership, all governments summarily abolished the last vestiges of the gold standard and enthroned the U.S. dollar as world money. They made the U.S. government and its Federal Reserve System the central banker of the world. This banker obviously may expand or contract his accommodations, dispense or withhold his favors and thereby determine the liquidity or illiquidity of the world. He may kindle a world boom or squash it with deflation and depression; the world depends on his discretion and wisdom.

Automatic Stabilizers

The new monetary order seems to aggravate the severity of the business cycle. The 1981-1983 depression proved to be immeasurably more painful and potentially more destructive than the depression of 1973-1975, which in turn was the worst since the Great Depression. And yet, despite the visible recurrence of painful cycles and in spite of their growing severity, many American economists point with confidence to the “automatic stabilizers” that are said to alleviate the disruptions. They derive comfort and confidence from the vast expansion of government, the “stabilizing influence” of the income tax, the growth of unemployment insurance and programs of social security. As a result of these changes, personal income has lost its direct link with the fluctuations of production. In fact, when industrial production falls significantly, total output may decline very little, and the aggregate of personal income, especially after-tax income, may not decline at all because government collects much less in taxes from corporations and individuals, but spends much more on unemployment insurance and social security payments.[10]

Unfortunately, all these “instruments of stability” are merely contemporary manifestations of the sovereign power over money and the right of government to inflate and depreciate the money. If it were not for this power and the ever-active printing presses that seek to stimulate and energize the sagging “private sector,” a deep depression would engulf economic production. The vast expansion of government does not impart economic stability; it imposes a crushing burden on economic life and serves to destabilize it. Boosts in social security taxes or unemployment insurance taxes do not stimulate economic life; they depress it and create ever more unemployment.

When government resorts to inflation in order to stimulate activity and alleviate unemployment, it makes matters worse. Inflation disarranges the production process, rearranges the distribution of labor among industries, and thereby makes more and more workers dependent on the continuation, often even on an acceleration, of the rate of inflation. When, in the end, the inflation ceases or slows down, labor must scramble to readjust and return to more productive employment as prescribed by consumer choices and orders. The read justment process may be slow and painful, the unemployment severe and prolonged.

Many economists rejoice about the visible shift of employment from basic industries to service industries, which affords new hope for more stable conditions. Manufacturing, mining, construction, and transportation are the most volatile industries; service industries such as health care and education are said to be more stable. But such hopes, too, are built on the power of government to engage in currency and credit expansion in order to finance the steady employment in the service industries, several of which, after all, either are owned outright by government or heavily subsidized by government. The steady employment of many doctors and teachers squarely rests on the taxing power of government and the effectiveness of its printing presses. It will draw to a close as soon as government loses some of its power either through tax rebellion or hyperinflation, or both.

Old Hazards and New Hope

The old hazards of cyclical unemployment continue to loom on many labor markets. After more than fifty years of strenuous contracyclical effort at all levels of government and nearly forty years of a congressional mandate articulated as the Employment Act of 1946, the forces that create cyclical movements have not vanished. In fact, they are growing in strength especially in those industries that rely on government favors. While the forces of depression are gaining, many Americans continue to cling to the expectation that the federal government will intervene with vigorous monetary, fiscal, and regulatory actions in order to check any depression that develops. But events are beginning to shake this confidence in political wisdom; they are likely to weaken it further in the years to come.

There is new hope. To distrust party politics and government coercion in economic matters is the beginning of economic knowledge and wisdom. []


1.   “The Analysis of Economic Change,” Readings in Business Cycle Theory (Philadelphia: The Blakiston Company. 1951), p. 2.

2.   A. C. Pigou, Is Unemployment Inevitable? (London: Macmillan & Company, 1924), p. 98; also Pigou, The Theory of Unemployment (London: Macmillan & Company. 1933).

3.   F. W. Taussig, Principles of Economics (New York: The Macmillan Company. 1947). Vol. I1, p. 81.

4.   Lord Lauderdale, An Inquiry into the Nature and Origin of Public Wealth (1804. 2nd ed., 1819), p. 364.

5.   T. R. Malthus, Principles of Political Economy (1820), p. 392.

6.   Karl Marx, Capital, Vol. I1 (Moscow, 1961). pp. 185-186.

7.   J. M. Keynes, General Theory of Employment, Interest, and Money (New York: Harcourt, Brace and Co., 1935), p. 55.

8.   Ludwig von Mises, Human Action. 3rd rev. ed. (Chicago: Henry Regnery, 1966). pp. 780-803.

9.   F. A. Hayek, Unemployment and Monetary Policy (San Francisco: Cato Institute, 1979),; also A Tiger by the Tail (London: Institute of Economic Affairs, 1972).

10.   Milton Friedman, “Why the American Economy is Depression-Proof,” Dollars and Deficits (Englewood Cliffs. N J: Prentice-Hall, Inc.. 1968).

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