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Inflation v. Unemployment

Economics / Inflation May 02, 2008 - 09:55 AM GMT

By: Gerard_Jackson

Economics It says much about the lousy state of economic debate that the 1993 study The Costs of Unemployment in Australia , produced by the Economic Planning and Advisory Council and co-authored by Raja Junankar and Cezary Kapuscinski, is still being touted as a piece of sound economics. At the heart of this study is the grave economic error a "fight inflation first" policy generally incurs more costs than benefits.


I can still recall this study being favourably reviewed by Michael Stutchbury in The Australian Financial Review . My opinion of the thinking behind the paper not only remains unchanged but has hardened further. (I am no longer prepared to make excuses for those whose 'economic' education results in monstrosities like this study). The reason is that even though a number of years have passed no attempt has been made by economic commentators, both in the media and in our so-called think tanks, to establish a link between inflation and the higher levels of unemployment that have emerge at the end of each boom.

The striking thing about the study is that, like those who reviewed it in the media, it showed a startling degree of ignorance of those aspects of monetary and capital theory that render such studies theoretically worthless, if not actually dangerous. The study was fatally flawed by two factors:

1. The authors' implicit assumption — and one shared by our economic commentariat — that money is neutral in the sense that increases in the quantity of money only influence the price level and not individual prices, thus leaving the structure of relative prices unchanged along with the capital sturcture.

2. They adopted the neoclassical approach of treating capital as a homogeneous blob and not a heterogeneous structure.

The authors, as are most economists, are utterly ignorant of the vitally important fact that any increase in the quantity of money will alter the structure of relative prices; meaning that monetary expansion will not change all prices at the same time or to the same extent or degree. The effect of monetary expansion, particularly when it largely consists of credit, is to distort the capital structure, causing malinvestments, i.e., investments that would not ordinarily pay for themselves and would therefore not be undertaken unless there was a fall in interest rates.

As the much ignored Austrian School* continually points out new money is injected into the economy at different points. These monetary injections change the distribution of the money stream between all the stages of production. This monetary process misdirects labour and capital into lines of production whose activities are become dependent on increasing the quantity of money. Once the central bank is forced to apply the monetary brakes, as eventually it must, the misdirected labour and capital (the malinvestments) reveal themselves in the form of excess capacity and rising unemployment.

It follows that the critics of a "fight inflation first" policy are committing a serious and inexcusable error. The unemployment they are attacking is not the cost of fighting inflation at all — it is the price that must be paid for having inflation. The phenomenon of a higher level of unemployment after each monetary crunch can be explained by governments returning to inflationary policies before the malinvestments from the previous inflation have been liquidated.

The problem of persistent widespread unemployment is, however, caused by raising the cost of labour services above their market clearing rates. For this we can thank a callous union movement, its Labor Party allies as well as its academic and media mates. The latter because they continually attack, without any serious attempt at a refutation, those who have the temerity to publicly tell the truth about unemployment and labour costs. It needs to be said, however, that in Australia the defence of free labour markets has been handled with incredible incompetence along with a staggering ignorance of economic history and how labour markets work.

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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