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Home | Blog | Deficient Demand or Structural Unemployment: Hayek, Keynes, and Phelps

Deficient Demand or Structural Unemployment: Hayek, Keynes, and Phelps


Russ Roberts at Café Hayek highlights a 2011 paper by E. Phelps on Hayek-Keynes and the recent crisis and current slow recovery. Roberts quotes the end of Phelps’s paper which is strongly anti-Keynesian:


What now do we do? With some luck, the economy will “recover” through a return of investment activity to sustainable levels once some capital stocks, like houses, have been worked down. But it will not recover to a strong level of business activity unless something happens to boost innovation. The great question is how best to get innovators humming again through the breadth of the land. Hayek himself said little on innovation. But at least he had an applicable theory of how a healthy economy works.


The Keynesians, sad to say, show no understanding of how the economy works. They think they can lever employment up or
down by pushing buttons – as if the economy were hydraulic. They show no grasp of the concepts that would be necessary to restore us to prosperity and flourishing. In an old image that applies well to the posturing of today’s self-styled Keynesians, “the Emperor has no clothes.

Marcus Nunes at Historinhas argues Phelps gets it wrong – the current problem is deficient demand not structural.

Phelps: “The evidence: Inflation is running at about 2% again. The expected rate of inflation at 1.5% or so. Consequently, we do not have a “deficiency of demand” now!”

Nunes: “And then he comes peddling his 1994 book “Structural Slumps”:”

Phelps: “So what do we have? We have a structural slump! We are slowly coming out of a structural slump – thanks to structural forces, such as wealth decumulation and a build-up of untried ideas for innovation.

If the present slump is wholly or largely structural, Keynes’s theory of employment, since it’s monetary, does not apply to the slump”.

Nunes: “He [Phelps] gets it wrong. The Fed provided liquidity to banks, but did not increase the money supply in order to match the increased money demand. Therefore, the monetary-induced, not structural, slump.”

The current unemployment is structural in a Hayekian sense – its root is significant misdirection of production. Sustainable recovery will require liquidation of malinvestments and a reallocation of resources into a pattern of production more closely in line with consumer preferences, including time preference, and resource availability (see Cochran, John P. (2010), “Capital in Disequilibrium: Understanding the “Great Recession’ and Potential for Recovery,” Quarterly Journal of Austrian Economics, 13, no. 3, 42-63 and Hayek’s Critique of The General Theory: A New View of the Debate between Hayek and Keynes, by David Sanz Bas).

My conclusion relative to commentary by Phelps (“False Hopes for the Economy and False Fears,” Wall Street Journal, June 3, 2003), re the first recession of the century remain valid:

Without the credit created malinvestments, the U.S. economy, instead of returning to Phelps’s normalcy, would potentially be on a permanently higher growth path albeit not one as high as the one generated by the credit creation. The consequences of the malinvestments should thus be a legitimate concern, and if there are significant interferences to the necessary market adjustments; bankruptcies, liquidations, declines in wages and resource prices in markets where the resources are no longer needed, and relocation of capital goods and labor to areas consistent with the pattern of demand, these concerns should turn into legitimate fears.


But, not to end on too negative a note, we must agree with Professor Phelps, “We need to guard against European corporatism and old fashion cronyism. The real hope is that the enterprising spirit is so strong here that, even if the system is not tuned up for the best, there will continue to be enough upstart entrepreneurs and established ones that will hit upon ideas for new products and methods worth developing and trying to market.”


But whereas Phelps would “look forward to normal times, with their ups and downs,” with a greater understanding of ABCT and its greater acceptance by businessmen and policy makers, we could look forward to greater prosperity without the ups and downs associated with boom and bust.

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