Keynes Said Inflation Fixed the Problems of Sticky Wages. He Was Wrong.
Britain’s economy had been suffering chronic unemployment for a decade prior to 1936. Economic theory as it was then understood clearly showed that the cause of a market surplus was sellers asking a price in excess of what buyers are willing to pay.
If buyers and sellers simply disagree, then so be it. But if the situation is aggravated by excessive regulation or other institutional problems, then economists would advise dissolving institutional barriers that prevent the smooth functioning of the market price system. Contemporary British economists were aware that labor union contracts fixed wages above market-clearing levels and that unemployment subsidies were a factor in preventing labor markets from clearing.
The revolutionary John Maynard Keynes rejected the orthodox view. In his 1936 book The General Theory of Employment, Interest and Money, he proposed a wholly different approach. While carefully obscured in a sophisticated model, Keynes’s solution was simple: to leave nominal wages alone, but lower real wages through inflation. If business firms understood the difference, then when real wages reached an attractive level, they would begin to hire at the union pay scale.
In his critique of the Keynesian revolution, the British Austrian school economist William H. Hutt made compelling arguments against the use of inflation as a substitute for market prices. Hutt made several arguments for the superiority of sound money over inflation. Here I will look at several of his ideas.
Price Coordination versus Inflation
Hutt showed that lowering real wages through inflation is not the same thing as market price adjustments under sound money. Coordination means all producers making the best use of scarce factors to produce more of what consumers want at lower cost. The cost is less production of things that consumers care less about. Coordination requires prices driven by competition among entrepreneurs and scarcity of the factors. A well-functioning price system will bring idle labor and capital goods into use at lower prices, so they may contribute to alleviating scarcity. A lack of price coordination was at fault in the British labor markets.
Better coordination would have required many individual price adjustments, “countless widespread and deliberate acts of coordination.”1 Specific market price changes driven by the profit-seeking and loss-avoidance motives of entrepreneurs was needed. The prices most in need of adjusting were the wages of the unemployed. Each worker could have found work of their own choosing, either accepting the highest available wage, or the best offer they could find in the occupation they preferred.2
The main problem Hutt saw was that unemployed workers were asking for a wage above the point where the market for their services would clear. These wage demands were mostly intermediated through labor unions, who were trying to extract a benefit for their members at the expense of the nonunionized part of the workforce. The public at large in their role as consumers lost out either through higher prices or less supply, if they were willing to pay more. The effect of the union’s demands, if met, would be to drive up costs and prices in their industry and force the remainder of the system to adjust. If the consumer was not willing to cooperate, the unions only succeeded in pricing their membership out of a job.
A wage rate fixed above market clearance in one industry displaced workers into either unemployment or underemployment. If not out of work altogether, workers would be doing something that either paid less or working in an occupation that was not their first-choice line of work.
From a distance, if you squint, it might appear that lowering real wages through inflation achieves approximately the same thing as cutting nominal wages. So long as the prices of the goods that businesses sell and wages remain the same, and if other input costs do not rise any faster than their output prices, then real wages would fall. Business selling prices will rise to the point where it makes sense to hire workers at the wage they are holding out for—without the need for a political confrontation with labor unions.
One of the effects of this type of inflation is that it would lower wages in all sectors and industries where it was not anticipated, or in which there were contracts or other long-term agreements. A free price system would instead result in lower wages for those markets in surplus without collateral damage to other workers.
But as Hutt showed, inflation is not a good substitute for many entrepreneurial actions—each one changing a few specific prices. Compared to price adjustments, inflation is a blunt instrument. Rather than the prices of items in most oversupply falling the most, as would happen with market pricing, under inflation, the least obstructed prices will rise the most. Cantil
Article from Mises Wire