Why unemployment persists in recessions

Previously, I’ve explained the view of the Austrian school on what causes recessions – the boom and bust cycle caused by manipulating interest rates, and the money supply.

But what causes the recession to continue, and unemployment to persist?

The simple answer is that prices are not allowed to adjust. During the boom, unsustainable  projects are set in motion. The quickest way to return to growth and full employment once the boom ends in a bust, is to allow prices that have been inflated to fall back to market levels. This means allowing banks to fail and mortgages to be foreclosed.

In Britain, the US, and across the Eurozone, the response has been the opposite. We’ve had measures to try to extend the housing boom, even lower interest rates, quantitative easing and massive bailouts of some of the worst run banks in the history. All these things perpetuate the unsustainable projects.

The trouble is that politicians are too afraid to allow businesses to fail, and too in hock to their paymasters at the large corporations. A reading of previous recessions, such as the experience in the US during 1920-21, and the immediate aftermath of the stock market crash in 1929, shows that economies can recover very well if markets are allowed to restore the balance and meet real demand. It was the massive interventions of Hoover and FDR that caused the Great Depression.

The Keynesian notion of the “circular flow”, whereby one man’s income is another man’s spending, leads to the view that if we do nothing, the economy will spiral down and never recover. As unemployment spreads, the reduction in spending then impacts other businesses, which then go on to also cut staff. Whilst the circular flow is superficially true, it fails to account for the changes in prices economy-wide that will lead to a return to growth. In a free economy, rising unemployment will lead to lower wages, which allows business to take on more staff. The falling wages are also cushioned by a general fall in prices – the opposite of our current recession, where we have rising unemployment, stagnant wages, and significant inflation.

Of course, the best thing would be for politicians and central bankers to pay attention to the most important lesson from the Austrian school – and prevent the boom from starting in the first place. Stop siphoning money to your friends in the City and on Wall Street and let’s have truly sustainable growth.

 

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