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D EPARTMENT OF E CONOMICS

L ABOR E CONOMICS FROM AN A USTRIAN P ERSPECTIVE

P ETER J. B OETTKE

AND W ILLIAM J. L UTHER

George Mason UniversityDepartment of EconomicsWorking Paper No. 12-41


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Labor Economics from anAustrian Perspective

Peter J. Boettke George Mason University

William J. Luther Kenyon College

Abstract:

The compelling case offered by Austrians regarding the recent economic downturn

has no doubt encouraged many to take a closer look at the broader Austrian perspective. Similarly, the jobless recovery has prompted some soul searching inlabor economics. We briefly review the history and methodology of the Austrianschool and describe major contributions to labor economics from those working in theAustrian tradition. Then, we offer a sketch of the Austrian theory of labor marketsand discuss its implications. In doing so, we hope to have helped the interested readeralong both lines.

JEL Codes: B53, E00, E2, E3, E4, E5, E6, J00, J2, J3, J5, J6, J7, J8

Keywords: Austrian, Austrian business cycle theory, Bhm-Bawerk, entrepreneurship,

Hayek, labor, labor theory of value, marginalism, Mises, search, uncertainty,unemployment

Email: [email protected] Address: Department of Economics, George Mason University, MSN 3G4,Fairfax, VA 22030 Phone: 703.993.1149 Email: [email protected] Address: Department of Economics, Kenyon College, Ascension Hall #305,Gambier, OH 43022 Phone: 740.222.1242


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The US has experience persistent high unemployment in recent years. According to the

Bureau of Labor Statistics, the unemployment rate, which averaged roughly 5.3 percent

from January 2002 to January 2008, grew steadily from 5.0 percent in January 2008 to

10.0 percent in October 2009. Having declined somewhat, it remains significantly higher

than the pre-recession average. The unemployment rate hovered around 8.2 percent

during the first five months of 2012. With GDP increasing on average since June 2009,

many economists, journalists, and pundits have described the end of the Great Recession

as a jobless recovery . Although everyone seems to agree that the US is experiencing a

jobless recovery, there is considerably less agreement as to why this is the case.Speculation surrounding the jobless recovery stands in sharp contrast to the strong

consensus that has emerged concerning the proximate causes of the housing bubble and

subsequent recession. Although some continue to blame a global savings glut, structural

change, and/or lack of financial regulation, most economists now accept that the Federal

Reserve held interest rates too low from 2001 to 2006, thereby generating an

unsustainable bubble. John Taylor (2009a, 2009b) and the late Anna Schwartz (2009)

have been particularly influential in promoting this view among mainstream economists.

However, as Scott Sumner (2009) notes, the position advanced by Schwartz (and,

therefore, Taylor) more closely resembles the Austrian business cycle theory than the

Monetarist view she and Milton Friedman once popularized. 1

Several economists explicitly linked to the Austrian tradition have offered

commentary on the recent boom and bust. Boettke and Luther (2009), Horwitz (2009a),

Horwitz (2009b), Horwitz and Boettke (2009), Horwitz and Luther (2011), White (2008),

1 Were he alive today, Sumner (2009) writes, Friedman would be horrified by the neo-Austrian views ofAnna Schwartz. For a concise review of the differences between Austrian and Monetarist perspectives, seeGarrison (2006).


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and White (2009), among others, generally accept the view put forward by Taylor and

Schwartz regarding the origins of the bubble 2 If disagreement exists between

Taylor/Schwartz and the Austrians, it concerns the nature of capital and labor specificity,

the need for a period of adjustment following the boom, andmore generallywhat

could and/or should be done to get out of the present mess. As a result of these works and

others, the Austrian business cycle theory is once again a contender in the realm of

macroeconomics.

Given that the Austrian explanation of the recent recession is so compelling, a

natural question follows: What do the Austrians have to say about unemployment, in particular, and labor economics, in general? After briefly reviewing the methodological

framework of the Austrian school, we survey contributions to labor economics from

traditional and modern Austrian economists. In Section 2, we sketch a model of labor

markets from an Austrian perspective. Implications of this model are made explicit in

Section 3. Our primary aim is to familiarize the reader with the Austrian perspectivenot

to answer all questions arising from within the Austrian tradition or between Austrian and

mainstream economists. We hope the interested reader will follow the sources contained

herein to address such questions.

1. Survey

Austrian economics originated in Vienna in the 1870s with the publication of Carl

Mengers Principles of Economics . Although the ideas expressed by Menger contrasted

sharply with those held by many of his German-language colleagues, they were firmly in

the tradition of mainline economics stemming from Adam Smith, David Hume, and Jean- 2 The historian Tom Woodss (2009) also takes the Austrian position.


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Baptiste Say. Along with William Stanley Jevons and Lon Walras, Menger contributed

significantly to the marginal revolution in economic thought. As a result, early

Austriansincluding Eugen Bhm-Bawerk, Friedrich Wieser, Hans Mayer, Ludwig von

Mises, Gottfried Haberler, Friedrich A. Hayek, Fritz Machlup, Oskar Morgenstern, and

Paul Rosenstein-Rodansaw themselves as contributing to the principle body of

economics. They held prestigious positions in the academy, published in the top journals

of the day, and were highly regarded in the profession.

Only in the late 1930s and 1940sduring the two great debates of that erawas

the uniqueness of the Austrian perspective revealed. Debates over the causes of and proper response to fluctuations in economic activity with John Maynard Keynes and the

feasibility of economic calculation in the absence of private ownership of the means of

production with Oskar Lange and Abba Lerner showed that Austrians were more keen to

view the market as a process of interaction and less accepting of aggregate conceptions

than their non-Austrian colleagues. 3 As the profession moved toward mathematical

formalism and empiricism in the 1950s and 1960s, and Austrians more clearly articulated

their views of the market process and radical uncertainty in the 1970s and 1980s, the

distinction became sharper. Over the last two decades, Austrian economics has occupied

a somewhat peculiar domain between the mainstream profession and approaches that are

clearly heterodox. Nonetheless, many Austrians still see themselves as working in the

mainline tradition of economics. 4

Before reviewing contributions to labor economics from those working in the

Austrian tradition, it is useful to summarize the core methodological components of the

3 See Lavoie (1985) and also Boettke (2001) and (2012, chapter 16).4 Boettke (2007) distinguishes between mainline and mainstream economics. See also: Boettke (1996),Boettke, Fink, and Smith (2011), and Boettke (2012).


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Austrian school for those readers less familiar with the approach. In addition to enabling

one to identify common themes in the various works presented in this section, clarifying

our conception of Austrian economics will also provide some context for the theory of

labor markets articulated in Section 2 and the implications of that theory discussed in

Section 3. As our summary of the Austrian core is intentionally brief, the interested

reader is directed to Boettke (1997), Boettke and Leeson (2002), Caldwell (1994),

Kirzner (1997), Lavoie (1994), Martin (2009), Selgin (1988), and White (2003). 5

1.1 The Austrian Core

Since the schools inception, Austrian economists have strictly adhered to

methodological individualism. Economics is first and foremost the science of human

actionthe study of choosing between scarce resourcesand Austrians maintain that,

ultimately, the individual is the only entity capable of such choosing. 6 To the extent that

one speaks of a corporation, government, or other group making decisions, it is merely

shorthand for a process in which individuals act. Moreover, individuals are presumed to

act purposively, a term designating a weak form of rationality wherein individuals

choose means they believe will satisfy their given ends. Hence, Austrian economists can

be said to employ a rational choice framework at the level of the individual.

Although Austrians employ a rational choice framework, they differ from many

mainstream economists in that they are thoroughly subjectivist. Rationality, to an

Austrian economist, denotes intention rather than omniscience. So long as one chooses

5 Backhouse (2000) provides a non-Austrians perspective on Austrian economics.6 There has been some disagreement regarding whether theories of group selection put forward by Hayekare in fact consistent with methodological individualism. See Caldwell (2001, p. 548-51) and the citationscontained therein.


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the means he believes are best suited to accomplish his ends, he is acting rationally.

Austrians commonly assume experiences inconsistent with expectations lead individuals

to revise their beliefs. Nonetheless, holding objectively false beliefs is not typically seen

as irrational.

The value theory accepted by Austrians is similarly subjectivist. Goods are

valuable insofar as individuals find them useful. Goods are not endowed with a fixed

amount of usefulness. Early Austrians bucked hard against the labor theory of value and

similar input-based approaches. Rather than being determined by objective costs, supply

curves in the Austrian framework reflect the subjective valuation of foregoneopportunities. Whereas demand curves depict the price one is willing to pay for an item,

as governed by the value the item has to potential buyers relative to other goods that

might be obtained, supply curves depict the price one must be compensated in order to

give up an item, similarly governed by the usefulness of the item to the seller relative to

alternatives. They are marginal benefit and marginal cost curves, where benefits and costs

refer to the subjective valuations of individuals.

Perhaps the most salient feature of Austrian economics is its treatment of

information, which is presumed to be decentralizedspecific to individuals of a

particular time and place. In two important essays, Hayek laid the foundation for the

modern Austrian view. First, Hayek (1937) explains that the information required for

equilibrium was far greater than any single individual needed to conduct the pure logic of

choice. Whereas the latter required an individual have a subjective interpretation of the

data surrounding his decision, the former required consistency in the subjective

interpretations of all acting agents since, in equilibrium, all planned courses of action


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must be compatible. The question, then, is how the spontaneous interaction of a number

of people, each possessing only bits of knowledge, brings about a state of affairs in which

prices correspond to costs [] and which could be brought about by deliberate direction

only by somebody who possessed the combined knowledge of all those individuals (p.

49). In a second essay, Hayek (1945) offers an answer to this question. Rather than

depicting the market as a field of information over which individuals optimize, Hayek

expresses it as a process of social interaction through which the necessary information is

communicated. 7 Although information is decentralized and a change in relative scarcity is

only known by the man on the spot (p. 524), prices can act to coordinate the separateactions of different people in the same way as subjective values help the individual to

coordinate the parts of his plan (p. 526). In abbreviated form, by a kind of symbol,

Hayek (1945, p. 527) explains, only the most essential information is passed on and

passed on only to those concerned. Hence, prices emerge from bid-ask patterns, which

are based on individual-specific information; and these prices communicate the

individual-specific information necessary to obtain equilibrium to all market participants.

The out-of-equilibrium dynamics described by Hayek requires the process of

entrepreneurshipan idea of central importance to Austrians. Entrepreneurship occurs

when one identifies a profit opportunity, musters the resources necessary to seize it, and,

through the exploitation of that profit opportunity, brings the economy closer to

equilibrium. As Kirzner (1973) explains, entrepreneurs are alert to potential profit

7 In Hayeks (1945, p. 526) own words: The whole acts as one market, not because any of its memberssurvey the whole field, but because their limited individual fields of vision sufficiently overlap so thatthrough many intermediaries the relevant information is communicated to all. The mere fact that there isone price for any commodityor rather that local prices are connected in a manner determined by the costof transport, etc.brings about the solution which (it is just conceptually possible) might have been arrivedat by one single mind possessing all the information which is in fact dispersed among all the peopleinvolved in the process.


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opportunities. Like Hayeks man on the spot, the entrepreneur possesses information of

a particular time and place and, therefore, is in a unique position to recognize when

changing preferences or technology create an opportunity for arbitrage. By acting on this

information, the entrepreneur captures the profit made possible by the arbitrage

opportunity and produces a new order in which no profit remains.

Regarding entrepreneurship and the market process, three additional items are

worth mentioning. First, viewing the market as a process of social interaction leads to a

distinct view of competition. Rather than denoting a state of affairs (e.g., the absence of

profit opportunities), Austrians use the term competition to refer to the rivalrous activityof contestation that brings about such a state. Second, entrepreneurs live in a world of

radical (or Knightian) uncertainty that is distinguishable from mere risk. To put it

succinctly, entrepreneurs do not know what they do not know; there is genuine discovery

and genuine surprise. Their behavior cannot be reduced to optimization because they do

not know the underlying functions over which they would like to optimize. Finally,

Austrians view disequilibrium as the usual state of markets. Genuine discovery and

surprise implies preferences and technologies constantly change. Before entrepreneurship

can fully restore equilibrium, changing fundamentals generate additional profit

opportunities to be remedied. For this reason, Austrians prefer to think the economy

tending toward (as opposed to being in ) equilibrium.

Although it is not strictly part of the Austrian core, the aforementioned tenets are

usually accompanied by a cynical view of the state. 8 The general distrust of government

held by many Austrian economists primarily stems from the beliefs that purposeful

individuals are more likely to know what is in their own interest and more likely to

8 Along these lines, Boettke (1995) asks, Why are there no Austrian Socialists?


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possess the decentralized information necessary to accomplish their ends. In contrast,

governments are viewed as a group of distant individuals perhaps possessing some notion

of the average individuals interests but without specialized knowledge of time and place.

As a result, economists working in the Austrian tradition are generally skeptical that

government action (or, more correctly, the actions of individuals comprising government)

can more effectively accomplish the ends of specific individuals than those individuals

could on their own.

Modern Austrians have also been influenced, to varying degrees, by the Public

Choice tradition pioneered by James Buchanan and Gordon Tullock.9

Whereas traditionalAustrians largely accepted postulates of government benevolence in order to highlight the

knowledge problem, Public Choice economists call into question the motives of

government agents. Public Choice economists decry the bifurcation of human behavior

wherein individuals acting in the private sector are presumed to be self-interested while

those in the public sector are presumed to aim at improving social welfare. Drawing on

both approaches, many modern Austrians believe government action is plagued by both

information and incentives problems. That is, government agents possess neither the

information nor incentives to improve upon the decisions of decentralized acting agents.

1.2 Traditional Austrian Labor Literature

In large part, the contributions of early Austrian economists to labor economics merely

reflect the time in which they were writing. As Galloway and Vedder (2003) explain,

labor economists in the early twentieth century were almost exclusively concerned with

9 Boettke and Leeson (2004) explore early Austrian contributions to the economics of politics and discussthe prospect of synthesizing Austrian and Public Choice approaches. See also: Boettke and Lopez (2002),Ikeda (2003), and Boettke (2012, chapters 4; 8-11; 17).


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labor unions. Following in the footsteps of John Stuart Mill, Karl Marx, and others, some

early twentieth century economists held closely to an objective labor theory of value,

viewed low wages and the resulting income distribution as a problem, and sought a

solution in labor unions. At the same time, the development of marginal utility theory in

the late nineteenth century allowed an alternative view to gain traction, wherein existing

wages were thought to reflect the marginal productivity of labor. It was this conversation

that early Austrians found themselves in; and, as they were a product of the marginal

revolution, these Austrians tended to reaffirm the marginalist view.

Eugen Bhm-Bawerk was arguably the first Austrian economist to seriouslygrapple with questions in the realm of labor economics and, in particular, offer a

systematic rebuttal of then-popular socialist views regarding labor. In the first of a three-

volume work on Capital and Interest , Bhm-Bawerk (1884) took on the exploitation

theory of interest as expounded by the German economist Johann Karl Rodbertus.

Adhering strictly to the labor theory of value, Rodbertus had reasoned that any value of

the final product paid to a non-working owner implied workers were paid less than the

full value of their contribution to the product. Bhm-Bawerk rejected the labor theory of

value, but believed the analysis proffered by Rodbertus also failed to account for the

temporal nature of production. Even if labor were the only productive input, Bhm-

Bawerk argued, observing a sum of wages paid to workers less than the value of the final

product need not imply that workers were paid less than their contribution to the product,

since the production process takes place over time and payments to workers are rendered

prior to the completion of the product. As Bhm-Bawerk explained, present goods are

more valuable than future goods. Therefore, wages paid in the present should equal the


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present discounted value of the workers contribution to the final product. Hence,

differences in the sum of wages (at earlier periods) from the value of the final product (at

a later period) need not be the product of exploitation, even if labor is the only input in

the production process.

Although Bhm-Bawerks lasting contribution to Austrian economics concerned

production as a roundabout process taking place over time with the interest rate

coordinating the time-structure of production, his forays into labor economics did not

cease with the remarks on Rodbertus discussed above. Indeed, Bhm-Bawerk (1986)

took to task the entire Marxian system and was widely regarded in the broader politicaleconomy literature for doing so. 10 Since it is only of tangential interest to the present

work, his argument against Marx can be described succinctly. First, Bhm-Bawerk

explains how the law of value put forward by Marx in Volume III of Capital contradicts

his theory of value from Volume I. He then addresses the arguments put forward by Marx

to reconcile the supposed contradiction. Finding these arguments unsatisfactory, Bhm-

Bawerk pronounces the labor theory of value as the source of error in the Marxian system

and criticizes Marx for not employing a subjective theory of value.

Despite Bhm-Bawerks efforts, many early twentieth century intellectuals

continued to view prevailing wages as too low and sought remedies in labor unions or

outright socialism. Having attended Bhm-Bawerks lectures at the University of Vienna

between 1904 and 1914 (when Bhm-Bawerk died), Ludwig von Mises took up the battle

where his teacher had left off. Regarding socialism, Mises (1920) stressed the

impossibility of economic calculation in the absence of private property over the means

10 For example, consider that Thorstein Veblen (1906, p. 576)while reviewing the socialist system ofMarx in the Quarterly Journal of Economics cites Bhm-Bawerks work as the point of view of classicaleconomics.


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of production. 11 Then, as part of his influential book Human Action , Mises (1949)

returned to the question of labor unions.

In addressing the garbled ideas that form the main ideological foundation of

labor unionism, Mises (1949, p. 591) reaffirms the marginalist view wherein wages

reflect the marginal product of labor. Two characteristics of his exposition stand out.

First, he clarifies that labor is heterogeneous. A uniform type of labor or a general rate

of wages do not exist. Labor is very different in quality, and each kind of labor renders

specific services (p. 590). What is sold and bought on the labor market is not labor in

general, but definite specific labor suitable to render definite services (p. 594). Second,he describes the decentralized market process that brings the marginalist result about (p.

591):

As with all other sectors of the market, the labor market is actuated by theentrepreneurs intent upon making profits. Each entrepreneur is eager to buy allthe kinds of specific labor he needs for the realization of his plans at the cheapest

price. But the wages he offers must be high enough to take the workers away fromcompeting entrepreneurs. The upper limit of his bidding is determined by

anticipation of the price he can obtain for the increment in salable goods heexpects from the employment of the worker concerned. The lower limit isdetermined by the bids of competing entrepreneurs who themselves are guided byanalogous considerations. It is this that economists have in mind in asserting thatthe height of wage rates for each kind of labor is determined by its marginal

productivity. Another way to express the same truth is to say that wage rates aredetermined by the supply of labor and of material factors of production on the onehand and by the anticipated future prices of the consumers' goods.

It is important to recognize that, in contrast to the standard price taker model, the view

put forward by Mises is a price maker model. Entrepreneurs, in competition with one

another, bid up wages of imperfectly-substitutable laborers in order to accomplish the

distinct projects they believe will be profitable upon completion. As we show below,

11 Mises (1951) takes an even broader view of socialism, considering its economic and sociologicalcharacteristics.


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thereby encouraging entrepreneurs to invest in projects that take too long to complete.

When the prevailing interest rate returns to its natural level, entrepreneurs realize these

projects are unsustainable. However, the investments made during the boomlike all

investmentsrequire specific capital (i.e., it is not perfectly substitutable with the capital

required for other, less lengthy projects). A painful adjustment process occurs wherein

the capital employed during the boomwhich Austrians label malinvestment is

retooled and reallocated to sustainable projects. Without the appropriate capital to

produce desired goods and services during the process of adjustment, output and

employment stall.The Austrian business cycle theory, as formulated by Mises and Hayek, places

central attention on physical capital. Indeed, Garrison (2001) describes the Mises-Hayek

view as capital-based macroeconomics, in contrast to the labor-based macroeconomics of

John Maynard Keynes. 12 Ballante (1983) and others have argued that specialization over

time has placed human capital on or near equal footing with physical capital. Hence,

entrepreneurs making malinvestments in human capitalin much the same way as with

physical capitalmight be more relevant today than in the past. In a slightly modified

version of the Austrian business cycle theory, expounded on in Section 2.1.2 below, the

costly adjustment process requires retraining and/or relocating of labor in addition to the

retooling and reallocating of physical capital. 13

12 See also: Garrison and Bellante (1988).13 Although Austrians have traditionally offered a relatively tight theoretical model of the business cyclewith capital and interest at center stage, the idea of extending the theory to explain the particular depthand/or extent of an economic downturn is in no way new. Rothbard (1963), for example, goes beyond thenarrow confines of the Austrian business cycle theory in considering the role of policies enacted underHoover and Roosevelt.


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1.3 Modern Austrian Labor Literature

Perhaps surprising to those associating Austrian economics with a rejection of

empiricism, much of the modern Austrian labor literature is empirical in nature. For

example, Bellante and Picone (1999) empirically demonstrate flaws with the difference-

in-difference approach employed in the famous Card and Krueger (1994) case study.

They also show that using the original approach with improved data yields only one

statistically significant result: the New Jersey minimum wage law decreased employment

for young workers. 14 Although empirical in nature and often similar to work conducted

by mainstream economists, the Austrian labor literature has a distinct flavor. Specifically,modern Austrians working in the field of labor economics tend to focus on the

heterogeneity of labor, differences between public and private sector employment, and/or

the mutually beneficial nature of exchange.

Austrian labor economists have been quick to point out that the labor force is

comprised of heterogeneous agents. In the context of North-South pay differentials,

Bellante (1979) uses labor heterogeneity to explain the high correlation between in-

migration and out-migration. Assuming homogenous labor, many observers were puzzled

that migration from the low-wage South was largely offset by migration from the high-

wage North. In contrast, Bellante (1979) argues that laborers with particular

combinations of raw labor, formal education, on-the-job training, and experience move to

areas where their real wage is highest (as opposed to where the average real wage is

14 Bellante and Picone (1999) criticize Card and Krueger (1994) for (1) failing to consider substitution between table service and fast food restaurants, (2) failing to control for differences across the two statesconsidered, and (3) restricting analysis to too narrow a time period. To overcome the perceivedshortcomings of the original study, the authors consider (1) the entire food and drink industry, (2) thedifference between Pennsylvania and New York (since both are outside the purview of the New Jerseyminimum wage law), and (3) a longer time period. On Card and Kruegers work from a market process

perspective also see Glen Whitman (1996).


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highest). Hence, the observed cross movements of the labor force increase efficiency by

improving the mix of labor types in each region.

Following Becker (1957), Bellante, Kogut, and Moncars (1991) consider the

relative supplies of particular types of labor in the context of discrimination. Specifically,

they examine the effect of Hispanic population density on the relative earnings of Blacks.

The authors find support for the Becker model in that, as the population density of

Hispanics increases, the relative earnings of Blacks decrease. 15 Furthermore, they suggest

regional differences in the relative earnings of Blacks disappear once one accounts for the

population density of Blacks in the South. Along these lines, Bellante and Kogut (1996)argue that intra-regional differences in typically unobserved variables exaggerates the

difference between the relative earnings of Blacks in the South and Non-South. Again,

the idea is to trace the effects of heterogeneity in the labor force.

Austrian labor economists have made important contributions to the literature

regarding differences in public and private sector employment. Using the University of

Michigans Panel Study for Income Dynamics , Bellante and Link (1981) find that public

sector employees are more risk averse than private sector employees with similar levels

of human capital. The result, as they point out, is consistent with the widely-held view

that public sector employment is relatively stable. Belante and Long (1981) improve

upon earlier studies considering pay differences between public and private sectors by

including non-monetary compensation. Exemplifying the influence of Public Choice on

many modern Austrians, the authors make use of a competitive rent-seeking model to

explain their results. Ramoni and Ballante (2004) survey the literature concerning public

sector wage premia. More recently, Ramoni-Perazzi and Ballante (2007) apply propensity

15 On the relative earnings of immigrants, see Bellante and Kogut (1998).


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score matching methods to control for selection bias and the comparability of units. They

find that public sector workers earn 3.5 to 11.1 percent more than their private sector

counterparts.

Bellante and Porter (1992) explain the simultaneous decline of private sector

unionization and growth of public sector unionization. Consistent with methodological

individualism, the authors first clarify that collective bargaining in both public and

private sectors actually takes place between a corporate or government representative and

a union representative. As such, both sides suffer from a principal-agent problem. 16

According to the authors, the ability to transfer a corporationand, in doing so, captureany value that extends into the futureencourages entrepreneurial corporate managers to

discover and implement institutions that reduce agency costs. In contrast, an employees

right to work under a union-negotiated contract is non-transferable (i.e., it ends with

employment). Assuming some benefits of agency-cost-reducing institutions are realized

beyond the horizons of current union members, they will be less alert to such institutions

and have less incentive to implement them when there are costs to changing the status

quo. If (1) corporate managers are more likely to discover and implement agency-cost-

reducing institutions and (2) returns to collective bargaining depend on the bargaining

power of the employers agent relative to the bargaining power of the employees agent,

then one should expect corporations to reduce agency costs at a quicker rate and thereby

reduce the returns to unionization in the private sector. As the returns to unionizing fall,

16 As Bellante and Porter (1992, p. 246) explain, part of the problem stems from labor force heterogeneity:In addition, union members have different ages and work-life expectations, different marginal rates ofsubstitution between wage and fringe benefits, different levels of skill, and they differ in their willingnessto accept risk. There is a natural tendency to value activities differently. This increases the control problem

by diminishing the consistency of the signal that principals send to their agent and diffusing the monitoringefforts of the principals. The principal-agent problem becomes a many principal-agent problem.


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the practice of unionizing should decrease as well. Indeed, the authors show that private

sector union membership in the US fell from 38.8 percent in 1956 to 12.9 percent in

1988.

Having explained the downward trend in private sector unionization, the authors

then employ the same framework to explain the upward trend in public sector

unionization. Like unions, public sector enterprises often involve non-transferable claims

and are therefore less inclined than corporations to reduce agency costs. Furthermore, the

authors claim the relationship of unions and politics is symbiotic. Since union members

and government bureaucrats seek higher wages and employment, the collective bargaining environment in the public sector is less adversarial than that of the private

sector; and, relative to rationally ignorant voters ability to punish, it is easy for unionized

labor to reward public office-holders for rents. These factors increase the returns to

unionization. Consistent with this view, the authors show that public sector union

membership in the US increased from 13.4 percent in 1956 to 45.5 percent in 1988.

Bellante and Porter (1998) extend their analysis of private and public sector

employment to account for the overall growth of government. Many theories of the

ratchet effectthe idea that an increase in the size of government cannot be turned

back, even after the causes that brought it about are no longer presentrely on

ideological shifts (e.g., Higgs 1987), which are difficult to quantify. In contrast, Bellante

and Porter (1998) point to differences between public and private sector employment

some of which have been discussed aboveand, in particular, how these differences lead

to asymmetries across the two sectors over the business cycle. In the private sector, the

authors argue, employers can let go of trained workers with known abilities during


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recessions since the higher level of unemployment increases the likelihood that these

workers will still be available in the future. In expansions, however, private sector

employers are hesitant to bear the costs of screening and training since lower levels of

unemployment increase the likelihood that these workers will leave the position. Hence,

employment in the private sector is more sensitive to downturns than upturns.

Drawing on their earlier work, Bellante and Porter (1998, p. 615-16) maintain that

public sector employeesat least relative to their private sector counterpartsare

organized and politically active, creating a source of demand for labor that is

independent of the demand for its product. During recessions, when the private sectorexperiences higher unemployment, the effective wage premia experienced by public

sector employees grows. Public sector employees respond accordingly, expending more

resources to protect rents. The ability to organize for political activity, the authors claim,

is an advantage for those already employed in the public sector. As a result, it is more

costly politically to lay off public sector employees when demand for their services

decreases than it is beneficial to hire new employees when demand warrants (p. 616).

Hence, public sector employment grows relative to private sector employment in

recessions, while tracking closely during expansions. The combined result, as the authors

demonstrate empirically, is a smooth ratcheting up of the size of government.

Many modern Austrians address labor issues arising in the context of developing

countries. For example, some ask whether employment at sweatshops could possibly

constitute a mutually beneficial exchange. Powell and Skarbek (2006) find that most

sweatshop jobs provide an above average standard of living for their workers. Similarly,

after conducting interviews with sweatshop workers in El Salvador, Skarbek et al (2011)


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conclude that non-monetary compensation of factory employment is perceived to be

more desirable than alternatives along several margins. Although no one to our

knowledge denies the harsh working conditions of sweatshops, empirical work conducted

by Austrians suggests those employed in sweatshops fare better on average than they

would in the absence of such jobs. Powell and Zwollinski (2012) discuss the current state

of the debate.

Leeson and Hall (2007) take a comparative historical political economy approach

to examining labor standards in developing countries. Presuming a tradeoff exists

between income and labor standards, they focus attention on the optimal timing ofadoption for various labor standards. Specifically, they use incomes of highly developed

countries at the time labor standards were adopted to estimate a safe income threshold for

developing countries contemplating the adoption of similar labor standards today. For

example, GDP per capita (1990$) in 2001 equaled just $3,813 in Namibia, comparable to

that of the US in 1899. Since the US had banned indentured servitude in 1885, when

GDP per capita (1990$) equaled $3,106, the authors conclude it is safe for Namibia to do

likewise. In contrast, the US did not permit collective bargaining prior to the National

Labor Relations Act of 1935, when GDP per capita (1990$) equaled $5,467. This

suggests adoption of similar standards in Namibia today might be premature. Hall and

Thorson (2010) use the approach to analyze labor standards adopted in Guatemala in

2001. As with the work on sweatshops reviewed above, Austrians examining the

adoption of labor standards in developing countries insist on relevant comparisons.


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2. Modeling Labor Markets from an Austrian Perspective

Having reviewed the major contributions of Austrians to labor economics, we turn our

attention to expositing a model of labor markets we believe many Austrians would find

agreeable. The task of modeling labor markets from an Austrian perspective is somewhat

unusual given the skepticism toward formal modeling typically expressed by Austrian

economists. In order to accomplish this task while maintaining the substance and flavor

of the Austrian tradition, we first consider a simple model of labor markets. Using this

model as a foilas Austrians are apt to doenables us to articulate those features of the

market process commonly emphasized by Austrians. Our approach also facilitatescomparisons with the standard view, which the non-Austrian reader may find helpful.

Given their widespread use in labor economics, it is natural to start with a simple

search model. 17 The model developed by Stigler (1961) and applied to labor markets

shortly thereafter suffices in this respect. In Stiglers (1962) formulation, the net payoff to

a worker from search is , where and correspond to

the respective amount of search and wage in the two periods and is the average cost of

search. With wages given as a function of search, the worker need only calculate the

amount of search in each period that maximizes . Employers, searching for workers,

engage in a similar calculation. In Stiglers view, agents on both sides of the market

merely choose the sample size that maximizes the expected return to search.

In general, Austrians reach similar conclusions while expressing concerns with

the Stiglerian approach. Many Austrians doubt acting agents possess the requisite

information to search efficiently. In order to engage in optimal search, agents must

17 Luther (2012a) argues the search-theoretic models commonly employed in modern monetary economicsare similar to the equilibrium construct used by Mises (1949); but whereas Mises used a frictionless modelas a foil, modern authors attempt to imbed specific frictions into the model. See also: Luther (2012b).

! = w 1 + w 2 ! " (n 1 + n 2 ) n 1, n 2 w 1, w 2

!

!


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already know the underlying functional relationships; they must know, for example, how

much an additional unit of search will increase their wage. How do they know the

underlying functional relationships? Is this information also the product of search? If so,

the problem is pushed up another level and the question remains: how do the agents know

what they know? Furthermore, Stiglers approach merely considers whether an agent

should convert an unknown known to a known known; it leaves no space for unknown

unknowns. 18 The Austrians, as Boettke (2002, p. 267) writes, want to emphasize not

just the procient use of existing information, but the discovery and use of new

knowledge that comes into being only because of the context in which actors ndthemselves acting. The absence of radical (Knightian) uncertainty removes the prospect

of genuine discovery (i.e., acquiring new knowledge). Similar concerns arise in the

context of the sequential search models pioneered by Gronau 1971, McCall 1970, and

Mortensen 1970, wherein agents choose an optimal stopping point.

In contrast to the standard approach, we put forward a competitive market process

approach. 19 We allow for radical uncertainty, genuine discovery, labor heterogeneity, and

capital specificity. We discuss the role of entrepreneurship in coordinating economic

activity. Non-cyclical unemployment is addressed in Section 2.1.1. Unemployment

arising in the context of the Austrian business cycle theory is discussed in Section 2.1.2.

18 Whereas converting an unknown known to a known known can be accomplished by searching,discovering an unknown unknown is the product of browsing (Evans and Friedman 2011).19 Given the aforementioned criticisms of the standard approach, it is somewhat ironic that two self-ascribed Austrian economists (Peter Lewin and Walter Block) earned their advanced degrees under GaryBecker.


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2.1 A Market Process Approach to Labor Markets

Entrepreneurship is central to the Austrian approach to labor economics. In search of

hitherto unrealized profits, entrepreneurs initiate a process of discovery whereby

individuals acting in disequilibrium acquire the beliefs necessary to sustain equilibrium.

Although the process of entrepreneurial action is usually discussed in the context of the

overall economy, it is just as applicable to an individual market like the market for labor.

For convenience, we discuss entrepreneurs as distinct individuals acting on both sides of

the market. In reality, individuals often play multiple roles simultaneously (e.g., working

on a project while overseeing the work of others and coordinating other inputs in the production process). Nonetheless, we present the process of action for entrepreneurial

producers and entrepreneurial workers separately before considering their interaction.

Entrepreneurial producers devise plans to coordinate scarce resources in order to

produce distinct goods demanded by (1) consumers or (2) other producers intending to

use the goods as inputs to a more complex production process. The profit motive

encourages the entrepreneur to find less expensive combinations of capital and labor

capable of producing the desired output. At the same time, demand from other

entrepreneurs for these resources puts upward pressure on rental and wage ratessince

resources must be bid away from alternative uses. Some producers will be unsuccessful

in bringing their plan to fruition (perhaps because their plan conflicted with the plans of

others and they were unable to secure resources at the market rate) and must devise a new

plan. Others will see their plan through. After coordinating complementary labor and

capital, producing distinct goods, and delivering them to buyers, producers receive

valuable feedback from the profit and loss mechanism. Those experiencing losses revise


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their plans and, in attempting to bring these revised plans to fruition, bid up the prices of

resources they would like to employ. Those producers experiencing profits continue

employing the same strategy. However, the realization of profits has revealed to others

the success of the strategy, which is reflected by higher wage and rental rates for the

inputs to the successful production process. Having fully exploited the profit opportunity,

the successful producer continues with the production process earning a normal rate of

return. A diagram of the entrepreneurial production process is included as Figure 1.

On the other side of the labor market, entrepreneurial workers must make

strategic human capital investments in order to be compatible with the future plans of

entrepreneurial producers. The profit motive encourages the worker to invest in specific

forms of human capital with higher returns. After acquiring skills, they seek employment.

Workers that have acquired undesirable skills find it difficult to secure a position at an

agreeable wage and must revise their plan, which may require retraining or relocating.

Successful workers find employment and begin working, where on-the-job training and

experience might further improve their general, firm-, or industry-specific human capital.

Workers possessing highly desirable skills in short supply see their wages bid up by

entrepreneurial producers, enabling these workers to experience a greater than normal

Devise Plan SecureResourcesProduce

GoodDeliverGood

ExperienceProts

L o s s e

s

N or m al

R e t ur n

Figure 1 The Entrepreneurial Production Process


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rate of return on their human capital investments. The profit experienced in the short run

encourages other workers to make similar human capital investments, thereby increasing

the supply of labor with those specific skills and pushing the wage of such workers back

down to the point where they no longer earn an above average rate of return. A diagram

depicting the process of the entrepreneurial worker is included as Figure 2.

In this simple model of the economy, equilibrium results when all plans are

compatible. Equilibrium of the production process is characterized by a continuous

perpetuation of the sequence Secure Resources ! Produce Goods ! Deliver

Goods, wherein the mix of goods produced and deliveredas well as the process of

producing and delivering these goodsremains fixed and the producer earns a normal

rate of return. Labor market equilibrium can be characterized by the continuous

perpetuation of the sequence Seek Employment ! Work ! Invest in Human

Capital, wherein the employment of each worker at a particular point in the production

process is unchanged, the only human capital acquired is on-the-job experience, and

workers earn a normal rate of return on human capital. Disturbances from changing

preferences and technology render some plans incompatible and generate profit

Devise PlanInvest inHumanCapital

SeekEmployment Work

ExperienceProts

N or m al

R e t ur n

L o s s e s

Figure 2 The Entrepreneurial Worker


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opportunities to be exploited by alert entrepreneurs. As a result, changing fundamentals

will lead some entrepreneurs on both sides of the market to revise their plans, thereby

initiating an equilibration process towards the new equilibrium.

Of particular interest in the present context are the interactions occurring where

producers attempt to Secure Resources and workers attempt to Seek Employment

while the economy is tending toward (but has not yet reached) the long-run equilibrium.

Although these interactions might properly be characterized as searching in the Austrian

theory of labor markets, it differs subtly from the Stiglerian optimization problem

discussed above. The view expressed by Alchian (1969) comes closer to what we have inmind. Like Stigler, Alchian (1969, p. 109) starts by recognizing that collating

information about potential exchange opportunities is costly. However, he goes further

by (1) adopting a market process approach and (2) clarifying that the task of collating

information, or searching, can be performed in various ways. We discuss each in turn.

Alchian employs a market process approach in that he considers the out-of-

equilibrium dynamics whereby individuals discover equilibrium-consistent beliefs. In

equilibrium everyone has equal marginal rates of substitutions, Alchian (1969, p. 109)

writes, but how is that equilibrium approached? Unlike Stigler, Alchian does not

require equilibrium-consistent beliefs of the underlying functional relationships from the

outset. Instead, he claims beliefs over the underlying functional relationships are the

product of genuine discovery and might therefore be inconsistent in the short run. Rather

than jumping from the old equilibrium to the new equilibrium following a change in


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market fundamentals, a gradual transition occurs wherein individuals discover the new

equilibrium-consistent beliefs. 20

That Alchian takes a market process approach will not surprise those readers

familiar with his work. In an earlier article, Alchian (1950, p. 121) incorporate[s]

incomplete information and uncertain foresight and dispenses with profit

maximization to exposit an evolutionary approach to economics. He describes how the

economic system functions as an adoptive mechanism which chooses among

exploratory actions generated by the adaptive pursuit of success or profits. Agents

are in no sense omniscient; they are characterized by [a]daptive, imitative, and trial-and-error behavior in the pursuit of positive profits. They are not expected to select

successful strategies at the outset. Rather, the system selects those strategies that are

revealed to be successful. In this way, Alchian elaborates on a market process with

(merely) purposive agents.

In addition to adopting a market process approach, Alchian (1969) clarifies that

searching can be accomplished in many ways and, importantly, that the costs of search

may differ across its various forms. Specialization, in some cases, reduces the costs of

gathering and disseminating information about goods, jobs, or workers. This extension

suggests some unemployment is merely self-employment in information collection and

also gives scope for institutions to emerge which facilitate and economize on search

institutions entirely absent and, indeed, unnecessary in Stiglers model (p. 111). Brokers

and middlemen serve to illustrate the point. Since the middleman is a successful

20 In Alchians (1969, pp. 109-110) own words: Discovery of the variety of bids and offers and the best path or sequence of actual exchange prices toward an equilibrium requires costly search over the population ( emphasis added ).


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specialist in search, Alchian (1969, p. 112) remarks, his search costs are, by definition,

lower [] than for a nonmiddleman, nonspecialist. Stable prices, unemployment, and

queues are also considered means whereby costs are incurred to reduce search and other

marketing costs even more (113).

Comparisons with Section 1.1 reveal that the search theory espoused by Alchian

is consistent with the Austrian approach. Economic actors in Alchians model are

purposive (but not omniscient) individuals with subjective values and beliefs.

Information is decentralized and costly to acquire; and prices convey important

information to the individual regarding the relative scarcity of goods. Disequilibriumdynamics are of central importance and, as with the Austrians, the competitive market

process according to Alchian results from individuals (which Austrians label

entrepreneurs) pursuing profit opportunities in a world marked by uncertainty.

With a model of the labor market and a better understanding of the Austrian

conception of search, we consider potential causes of unemployment. We divide the

analysis into two sections. The first concerns non-cyclical unemployment. The latter

deals with unemployment associated with monetarily induced aggregate economic

fluctuation (i.e., the Austrian business cycle theory). In both cases, we offer comparisons

with the standard view.

2.1.1 Non-cyclical Unemployment

As discussed above, frequent changes in preferences and/or technology lead

entrepreneurs to revise their plans. Recall that plans require specific forms of capital and

labor. Inputs currently employed in a production process may be ill suited for an


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entrepreneurs revised plan. Hence, disturbances in the underlying fundamentals not only

result in revised plans, but also prompt the reallocation of available inputs. Some inputs

are unemployed during the reallocation process. Since the economy, according to

Austrians, tends toward (but never fully reaches) equilibrium, some unemployment (of

both capital and labor) is observed in what might be considered normal times (i.e., in the

absence of business cycles). Hence, similar to mainstream economists, Austrians believe

the natural rate of unemployment (of labor) is greater than zero.

Mises (1949, p. 598) makes a distinction between two types of non-cyclical

unemployment: catallactic and institutional. Catallactic unemployment is a market phenomenon. It results from the market process. From the perspective of the unemployed

worker, catallactic unemployment is more desirable than employment. Unemployment

in the unhampered market, Mises (p. 596-7) writes, is always voluntary. In the eyes of

the unemployed man, unemployment is the minor of two evils between which he has to

choose. Individuals choose catallactic unemployment when they are unwilling to work

at the prevailing, market clearing, wage. In contrast, institutional unemployment results

from interferences with the market economy. When legal restrictions push wages above

or hold the quantity of labor below their market clearing levels, a surplus of labor results.

Unlike catallactic unemployment, institutional unemployment is less desirable to the

unemployed worker than employment. Workers experiencing institutional unemployment

are willing but unable to work for the market-clearing wage. Individuals are worse off on

average by the unrealized gains from trade.

Although non-economists might find it strange to think individuals ever choose to

be unemployed, the motivations underlying catallactic unemployment will be familiar to


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most economists. According to Mises (1949, p. 596), there are at least three cases where

one might prefer unemployment. First, unemployment might be preferred if it facilitates

acquisition of a better job in the future. Accepting a job today might preclude

employment in a particular field at a later point in time. A watchmaker working

temporarily as a lumberman, Mises explains, might lose his dexterity, making it difficult

if not impossible to return to watchmaking in the future. Furthermore, looking for new

employment opportunities while working might take longer than if all efforts were

devoted toward the task; and one might need to break an existing contract when a

preferred position becomes available. Since these activities are costly, the costs mightmore-than-offset the benefits of remaining employed.

The second reason offered by Mises concerns seasonal variability. Some jobs are

characterized by seasonal fluctuation. Snowplow drivers are of little use in the summer

and retail stores often hire temporary workers during the busy holiday season. If seasonal

fluctuations are not fully offsetsay, by relocating regularly such that ones job is

always in season or, more generally, taking on multiple positions with negatively

correlated seasonal fluctuationswages in a seasonal industry will have to reflect the

inconvenience of seasonal employment in order to compete with non-seasonal

alternatives. In other words, workers will earn a premium while working in season if

doing so requires foregoing employment out of season.

Finally, Mises reminds the reader that monetary wages are not the only concern of

workers. Undesirable attributes of a position reduce the effective (i.e., monetary plus

nonmonetary) wage offered. For example, an individual might prefer not to accept a

position conflicting with his religious, moral, or political convictions. Similarly, a job


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might reduce ones social prestige (p. 596). Although popular speech often regards

such concerns as noneconomic, Mises maintains their significance in economic

decision-making.

In the three cases described above, one might reasonably ask whether laborers are

actually unemployed . In our view, the first case looks the least like unemployment. As

described by Alchian (1969), and reviewed briefly in Section 2.1, it seems reasonable to

think of workers forgoing employment in order to find a better job as being self-

employed. Their wage, which comes in the form of higher future wages, is deferred.

Nonetheless, they are employed in a distinct process of economic activitynamely,searching for a better position. Similarly, one might question whether it makes sense to

refer to seasonal workers as unemployed out of season. It is uncommon to think of a

banker as being unemployed over the weekend and between the hours of 6PM and 8AM,

when offices are closed and he is not working. Why then should we think of the seasonal

workerwhose employment contract (explicitly or implicitly) also denotes periods

during which she will not be workingas being unemployed? Of the three cases, the

third perhaps looks the most like unemployment. However, closer inspection reveals that

the question remains. Just as one can be employed producing safes to protect the physical

assets of others, one can also be employed producing ones own physical assets.

Similarly, one can be employed protecting the non-physical assets of others. A therapist

who helps with self-esteem issues can be said to protect ones view of self from eroding.

Why, then, would we consider the third case described abovein which individuals

protect their non-physical assetsas unemployment?


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The question of what constitutes unemployment follows naturally from the

subjectivism emphasized in the Austrian tradition. Working with capital to produce

distinct physical goods to be purchased by others is only one way in which individuals

might employ their time. Self-production is also production. Nonphysical goods are also

goods. And time spent producing nonphysical goods for oneself is no less employed.

However, it is difficult to exclude such instances of self-employment from empirical

measures of unemployment. Since a component of measured unemployment is, in fact,

labor devoted toward desirable production, it is useful to distinguish between two types

of unemployment. Austrians refer to catallactic unemployment , in which labor is actuallyemployed, and institutional unemployment , which denotes genuine unemployment (i.e., a

surplus of labor) from a subjectivist perspective.

The proportion of workers experiencing catallactic and institutional

unemployment at a particular point in time corresponds to the mainstream view of a

natural rate of unemployment. 21 To be clear, there is nothing natural about institutional

unemployment. It arises from unnatural interferences with the market economy.

However, mainstream economists often view legal changes as technology shocks

affecting the natural rate. From this perspective, the natural rate is in part a product of the

legal state of affairs and, as such, should include institutional unemployment. In the

absence of interferences with the market economy, the natural rate of unemployment

equals the catallactic unemployment rate.

21 Bellante (2005, p. 203) similarly claims the Austrian view of catallactic and institutional unemploymentcorresponds to the natural rate of unemployment, which mainstream economists commonly divide intostructural and frictional unemployment. Since, from an Austrian perspective, all unemployment has astructural component and since Mises (1949, p. 597-8) believed the term frictional was inappropriate, weavoid using both terms.


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2.1.2 Cyclical Unemployment

The business cycle theory pioneered by Mises and Hayek is, in some respects, similar to

the more familiar New Keynesian models dominating the profession. 22 In its most basic

form, the Austrian business cycle theory is a monetary misperceptions model (e.g., Lucas

1972; Mankiw and Reis 2002). The inability to distinguish relative price changes from

changes in the general price level (or, alternatively, that all information is not

immediately available but cascades over the economy in time) causes some prices to

adjust with a significant lag. In the short-run, money is non-neutral: changes in the supply

of money, ceteris paribus , cause aggregate economic activity to fluctuate.23

In whatfollows, we build a very simple model of the macro economy, use the model to present

the Austrian business cycle, and trace the implications for labor markets.

As discussed above in Section 1.2, the unique feature of the Austrian business

cycle theory is its emphasis on the capital structure. 24 A highly stylized version of the

capital-based production process is presented in Figure 3. In this depiction, known as the

Hayekian triangle, a sequence of inputs produces a single point output. The input

sequence can be broken down into stages of production, with the horizontal axis

measuring the time of each stage and the total time to completion. The vertical axis

measures the value of output. Hence, the value of a semi-produced good in a particular

stage of production can be deduced from the height of the hypotenuse at that stage.

22 The degree of similarity between the two approaches is admittedly contentious. See, for example, Zijpand Visser (1994), Butos (1997) and the citations contained therein. Although these articles compare andcontrast Austrian and (pre-Real Business Cycle) New Classical approaches, noted dissimilarities with the

New Classical view are, in virtually all cases, equally applicable to New Keynesian models.23 Many Austrians use the term monetary non-neutrality to denote Cantillion effects. We do not disputethe existence of Cantillion effects. However, the topic is well beyond the scope of this paper and would addunnecessary confusion to our analysis.24 Our presentation of the Austrian business cycle theory draws heavily on Garrison (2001). See also:Horwitz (2000).


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By allowing for a greater degree of specialization, a longer production process

enables one to produce more output. 25 However, longer production processes also require

additional time to completion; one must wait longer before consuming the end product.

Selecting a capital structure requires entrepreneurs take into account both the potential for

greater production and the cost of waiting. Whereas the former depends on the production

function of a firm, industry, or economy, the latter is reflected in the interest rate. Positive

25 Merely lengthening a production process does not guarantee greater production (e.g., includingunnecessary steps). Nonetheless, the output of those processes actually employed is positively correlatedwith the length of the production process since it is not in the interest of entrepreneurs to employ a lessefficient production process.

Stages of Production

F i n

al

G o o d s

Early Stages Late Stages

Figure 3 The Hayekian Triangle


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(negative) technology shocks are depicted by a steepening (flattening) of the hypotenuse,

thereby permitting greater (less) output for the same amount of production time.

Decreases (increases) in the interest rate cause the hypotenuse to flatten (steepen),

thereby enabling faster (slower) economic growth. Simply put, interest rates are used to

discount future values: a lower interest rate, by increasing the present value of future

output, encourages a more roundabout production processthat is, a process which takes

more time to complete. In this way, the depth of the capital structure depends, at least in

part, on the prevailing interest rate.

The Hayekian triangle is combined with a market for loanable funds and production possibilities frontier to form the three-quadrant Austrian macro model

presented in Figure 4. Since the capital structure, as depicted by the Hayekian triangle,

reflects the prevailing interest rate, the model must have some way of generating an

interest rate. Austrians maintain that interest rates are determined by the intersection of

supply and demand in the market for loanable funds, which is depicted in the lower right

quadrant of Figure 4. The supply curve S LF reflects the amount of funds savers desire to

lend at various interest rates. The demand curve D LF reflects the amount of funds

borrowers desire to invest at various interest rates. Equilibrium is determined when the

interest rate i* equalizes savings and investment.


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C o n s u m p

t i o n

Investment

Savings,Investment

I n t e r e s

t R a

t e

i*

S = I

SLF

DLF

F i n

al

G o o d s

Hayekian Triangle Production Possibilities Frontier

Market for Loanable Funds

Figure 4 The Austrian Macro Model


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The production possibilities frontier for the economy is included in the upper right

quadrant. Given that the market for loanable funds coordinates saving and investing

plans, total output over a period must be either (1) consumed or (2) saved and invested.

Hence, there is a tradeoff at the macroeconomic level between consumption and

investment. Combinations of consumption and investment inside the production

possibilities frontier would indicate that the economy is underperforming, whereas those

outside represent an overheating economy. Both are suboptimal. Individuals in an

underperforming economy would prefer to produce (i.e., consume and/or invest) more;

those in an overheating economy would prefer to produce less. Since the economy canmove beyond the production possibilities frontier, Austrians often refer to it as a

sustainable production possibilities frontier. Production beyond the frontier is

unsustainable in the sense that it can only be achieved while market participants are

fooled into thinking their actions are consistent with their preferences given the available

resources in the economy. In this way, the production possibilities frontier depicted in

Figure 4 is analogous to the vertical aggregate supply curve employed by mainstream

economists: both denote the natural level of output.

The three-quandrant Austrian macro model, in its simplest form, can be

summarized in the following way. Individuals choose either to consume or save. Savings

are transformed into investments through the market for loanable funds. The interest rate

emerging from the market for loanable funds sends a signal to entrepreneurs regarding

the optimal structure of production. Entrepreneurs coordinate capital and labor to produce

output in a manner consistent with the optimal structure of production. Since the new

output must also be consumed or saved, the process repeats.


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According to Austrians, macroeconomic coordination breaks down when the

prevailing interest rate deviates from the natural (market clearing) rate. Consider, for

example, the case where the central bank increases the money supply unexpectedly. In

the market for loanable funds, a net increase in bond purchases by the central bank looks

a lot like an increase in real savings. The perceived increase in savings is shown

graphically in the lower right quadrant of Figure 5 by a rightward shift in the supply of

loanable funds from S LF to S LF + m . Since it does not constitute a genuine increase in

savings, but rather an increase in money, the new supply curve S LF + m is depicted with a

dashed line . Market participants respond to the perceived increase in savings by biddingdown the interest rate from i* to i. Saving decisions are determined by the intersection of

the prevailing interest rate i and the original supply curve, S LF ; on the horizontal axis, we

denote the quantity saved S. Borrowing decisions are determined by the prevailing

interest rate i and the new supply curve S LF + m ; on the horizontal axis, we denote the

quantity borrowed I . In other words, when the prevailing interest rate falls below the

natural rate, savers save less and borrowers borrow more. The shortage of loanable funds

goes unseen, at least in the short run, as it is papered over by the credit expansion.

We can trace the results of disequilibrium in the loanable funds market to the

other two quadrants of the Austrian macro model. As savers save less (i.e., consume

more) and borrowers borrow more, the economy begins to overheat. The overheating

economy is depicted in the upper right quadrant of Figure 5 by the consumption-

investment bundle beyond the production possibilities frontier. At the same time, the

structure of production is distorted. The low interest rate encourages (and enables) some

entrepreneurs to take on longer production processes. However, consumption has also


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increased, leading some entrepreneurs to direct more resources toward final goods. The

combined result, depicted in the upper left quadrant of Figure 5, is a distortion of the

Hayekian triangle. Hence, the unsustainability of output is depicted in two ways: the

economy is operating beyond the production possibilities frontier and the structure of

production suffers from discoordination.

The distorted Hayekian triangle from Figure 5 is depicted again in Figure 6 so that

we might more clearly articulate the prevailing discoordination. For simplicity, we divide

the stages of production into three distinct periods: early, intermediate, and late stages.

Garrison (2005) describes two distinct signals sent by the prevailing interest rate and theirrespective effects on these stages of production. First, the lower interest rate has a time

discount effect that is, it lowers the cost of lengthier production processes. As a result,

some resources are diverted to early stages of production. Second, the increase in

consumption produces a derived demand effect . Entrepreneurs respond by diverting some

resources to late stages of production in order to satisfy the demands of consumers more

quickly. If the lower interest rate were backed by real savings, the Hayekian triangle

would pivot, lengthening the structure of production in a sustainable way. However, since

the lower interest rate results from unexpected monetary expansion, there is a real

resource constraint. Increases in early and late stagesshaded light grey in Figure 6

come, in part, at the expense of output in intermediate stagesshaded dark grey. 26 Once

26 As discussed below, there is also a net increase in output and employment so some resources are being pulled out of non-employment uses (e.g., leisure, search, etc.).


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C o n s u m p

t i o n

Investment

Savings,Investment

I n t e r e s

t R a

t e

i*

i

S I

SLF

S + mLF

DLF

F i n

al

G o o d s

Figure 5 Austrian Business Cycle


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the real resource constraint is realized, the boom turns to bust. And since resources have

been malinvested redirected to the wrong stages of productiona reallocation period

takes place wherein output falls to a point inside the original production possibilities

frontier.

Macroeconomic discoordination of the type envisioned by Austrians distorts labor

markets in two dimensions. The vertical change in employment is virtually identical to

the view held by most mainstream economists: aggregate employment (and total hours

worked) goes up during the boom and down following the bust. However, Austrians also

point to horizontal changes in employment wherein labor is misallocated during the

boomthat is, directed to unsustainable projectsand must be reallocated following the


F i n

al

G o o d s

EarlyStages

IntermediateStages

LateStages

Figure 6 The Distorted Hayekian Triangle


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bust. We describe both in greater detail in order to highlight the subtle distinction

between the two.

When monetary expansion initiates a boom, individual sellers clearly observe the

demand for their goods increasing. However, the decentralized nature of knowledge in

the economy precludes these sellers from observing the increase in aggregate nominal

spending. Sellers respond by raising prices and increasing inventories, thereby

encouraging producers to increase the supply of available goods. In order to increase

output, producers must employ more laborthat is, producers must hire new workers

and/or persuade existing workers to work more hours. In both cases, producers bid upwages to convince workers to forego alternative uses of their time (i.e., leisure or

employment elsewhere). Workers agree, in part, because they (like sellers) cannot easily

observe the increase in aggregate nominal spending. Hence, employment and wages rise

above their natural levels during the boom.

Although Austrians recognize the vertical change (i.e., overemployment) during

the boom, they are more apt to stress horizontal changes since mainstream economists

often disregard them. Accepting that aggregate employment increases does not require

accepting that employment increases evenly across all occupations. Since Austrians

maintain that the increase in output during the boom is primarily concentrated in early

and late stages, they similarly expect employment in early and late stages of the

production process to grow more rapidly than those in intermediate stages. The time

discount and derived demand effects discussed above encourage entrepreneurs in early

and late stage industries to bid some workers out of intermediate stage industries (and

non-employment) in order to increase output in those stages. Workers agree, in part,


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because they cannot easily observe that the production processes they are joining are

ultimately unsustainable. Recall that the vertical change referred to increases in wages

and employment on average during the boom. Horizontal changes, in contrast, denote

increases in wages and employment on average in early and late stages relative to wages

and employment in intermediate stages. Hence, Austrians maintain that wages and

employment increase on average during the boombut these increases are more

pronounced in early and late stages of production.

Vertical and horizontal changes in employment are similarly present following the

bust. Alchian (1969, p. 121) describes the vertical change in detail:A decrease in general demand causes an increase in unemployment because more

people will accept unemployment to engage in search, and unemployed personwill look longer. Wage earning opportunities will diminish in the sense that lowerwages are available elsewhere. People use time to learn that the failure to findother equally good job options as quickly as they thought they would, reflectsdiminished alternatives in general, not unlucky search. The discerned maximumoffers will be lower than if the structure of alternatives had not decreased. Thelower level and slower rate of rise of best observed options is at first taken as anunlucky string of searches, and so unemployment is extended in the expectation

of shortly finding that elusive best option. And with each person looking longerthe total number of unemployed at any one time will be larger. (Incomes fall andfeedback effect occurs.) Each now has the added task of revising his whole

pattern of expectations. Whereas he was formerly searching for a higher clearlyformulated expected wage, now he must learn that the best has deteriorated.

To put it succinctly, falling nominal spending leads to decreasing wages and employment

on average. The horizontal change results because, having been bid out of sustainable

projects during the boom, misallocated labor must now relocated to desirable production

processes. Indeed, Austrians maintain that the degree of misallocation (of both labor and

capital) can explain, at least in part, the length and severity of the recession. 27

27 Austrians also stress the uncertainty produced by discretionary government policy.


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Briefly answering two questions often aimed at Austrians when horizontal

changes in employment are emphasized helps clarify the Austrian view. First, why dont

workers just return to their pre-boom occupations (or leisure activities) where, according

to the Austrian account, the economy was operating at a sustainable level? There are

actually two layers to this answer. For starters, the framework employed to describe the

business cycle simplifies the complexity of the real world. Recall that Austrians see the

economy as tending toward rather than being in equilibrium at any given point in time;

but the business cycle theory starts by assuming the economy is in equilibrium. This

simplification gives a clear point to which the economy might returnan idea Austriansgenerally reject. Moreover, changes in underlying fundamentals over the period have

surely unseated the pre-boom equilibrium. Workers accepting positions in booming

sectors are, in some cases, replaced by new workers. These new workers will have

acquired job-specific skillssome of which were known to old workers but some of

which are entirely new. For example, old workers will not necessarily know how to

navigate new internal processes or how to communicate and work effectively with

coworkers hired after their departure. Similarly, old workers will have gained new habits

and modes of operation that might not fit well in their old environments and, at the same

time, might not be easy to dispense with. Since some things cannot be undone or

unlearned, the post-boom economy will be fundamentally different in some respects than

the pre-boom economy. Hence, even if the pre-boom equilibrium could be achieved, that

pattern of economic activity would no longer be consistent with overall plan

coordination.


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The second question that might be answered to shed light on the Austrian

perspective goes as follows: if unemployment increases as resources are reallocated

during the recession, why doesnt unemployment increase as resources are reallocated

during the boom? 28 Implicit in the question is the mistaken view that Austrians reject the

vertical change described above. As we have attempted to show, emphasizing horizontal

changesas Austrians are apt to dodoes not preclude the existence of a vertical

change. To clarify, we state the matter using Alchians (1969) view of search. Although

the return to specializing in searching (i.e., searching while unemployed) increases

temporarily during the boom, workers do not initially recognize the change in theunderlying distribution of offers and therefore do not engage in as much search as they

would if the change were obvious. Employers, by contrast, see the demand for their

products increase and search for workers. Hence, in a boom, much of the reallocation

takes place while many workers are employed and some workers are moving from long-

term non-employment (e.g., leisure) to long-term employment. Contrast this with the

period following the bust. Again, workers do not initially recognize the change in the

underlying distribution of offers. However, they now observe their own offers falling and

begin specializing in search for better offers. Hence, in a recession, many workers are

unemployed and some workers are moving from long-term employment to long-term

non-employment (e.g., leisure). Whereas workers would have engaged in more

specialization in search (i.e., unemployment) during the boom if they had recognized the

change in the underlying distribution of offers and believed the distribution to be

sustainable, they would have engaged in less search during the recession if they had

28 Krugman (2010) asks this very question.


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recognized the change in the underlying distribution of offers and believed the

distribution to be sustainable.

But the Austrian viewsome will replystates that unemployment results during

the recession because workers have the wrong skills. In other words, Austrians point to

frictions associated with horizontal changes to explain the period of adjustment. Arent

workers similarly ill-suited to change jobs during the boom? Of course, to some extent,

frictions are present in the boom as well. But during the boom, Austrians argue, the

perceived profit opportunities increase in early and late stage production processes such

that some entrepreneurs might prefer taking on a less than ideal candidateperhapsopting for more on the job trainingin order to capture some of the available profits.

After all, capturing some profits with a less-than-ideal employee is better than waiting for

the ideal employee if, by the time she is likely located, the profits have been

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