Mises Daily Articles
Recession or Depression?
Many people are finally saying the R word: Recession. The fundamentals don't look good. The externals are even scarier: dollar and stocks skidding, gold and other prices (particularly producer prices) rising. But what has tipped the psychological scales is the statistic no one has cared much about in many years: unemployment.
The actual rate is very low by any historical standard: 5%. What matters here is the direction of change. It jumped from 4.7%. In the old days, unemployment rates of 5% and 6% were considered "full employment" in the Keynesian models. If government attempted to push employment below that level (and it is absurd to think that anyone in Washington can control the economy in that way), it would risk setting off inflation, or so it was believed.
If the actual unemployment rate is low, why this wave of pessimism? All data in the postwar period of American economic history consistently show that an increase in the rate has coincided with the onset of recession. The parallel between the two is the most consistent feature of the business cycle. See the NBER list: 2001, 1990–91, 1981–82, 1980, 1973–75, 1970, 1960–61, 1957–58, 1953–54, and so on. In each case, unemployment begins to rise at the onset.
Now, keep in mind that the link between rising unemployment and recession is largely true by definition only. In other words, those charged with defining what is and what isn't a recession put a huge weight on rising unemployment. So of course it appears that weak labor markets are what push an economy into recession.
This is sheer fallacy, and a particularly dangerous one. Rising unemployment is a symptom of a recession, not its cause. If the critical problem of recession is unemployment, policy makers are tempted to address this one area to the exclusion of everything else.
Already, Bush administration spokesmen are talking about a "fiscal stimulus" to counter this trend. But why isn't this laughable on its face? Perhaps if Bush had been a famed penny pincher, you could see how a stimulus would make some sense on the surface. But it is hard to imagine a more fiscally profligate regime than the Bush administration. We can confidently say that more spending is not the answer.
The view that unemployment causes recession was one of the great errors of the New Deal and the Great Depression. The government looted the private sector and transferred it to visible jobs programs. It forced business to maintain high wages precisely when the market was attempting to equilibrate them downward. It increased the costs of hiring just when the costs needed to be lower.
None of it did any good; in fact, it delayed recovery for many years. Lionel Robbins, in his classic book The Great Depression, wrote this in 1934:
If it had not been for the prevalence of the view that wage rates must at all costs be maintained in order to maintain the purchasing power of the consumer, the violence of the present depression and the magnitude of the unemployment which has accompanied it would have been considerably less…. A policy which holds wage rates rigid when the equilibrium rate has altered, is a policy which creates unemployment.
Writing in 1931, in his book Causes of the Economic Crisis, Ludwig von Mises explained that there would be no involuntary unemployment in a free market. There will always be some unemployment in a market in the same way that there are houses that are empty and not selling and resources that are not being used for production. This isn't due to market failure but to individuals who have the freedom to lower their asking price, provided they are permitted by policy to do so and businesses are free to negotiate wages freely.
What, then, is the solution to unemployment?
The determination of wage rates must become free once again. The formation of wage rates should be hampered neither by the clubs of striking pickets nor by government's apparatus of force. Only if the determination of wage rates is free, will they be able to fulfill their function of bringing demand and supply into balance on the labor market.
There is an error even more fundamental than seeking an interventionist solution to the problem of unemployment. It is the attempt to seek a solution to the recession itself, as if it were the critical problem. Writing all throughout the 1930s, both Mises and F.A. Hayek tried to explain that the recession itself served a market purpose, in the same way a correction to an inflated stock market serves a purpose. It re-coordinates economic structures that have grown seriously out of balance.
In other words, they urged that we look back before the recession, to the good old days of economic boom, and realize the prosperity of the past was a partial illusion. The recession is the way that the economy tells the truth about the fundamentals. The illusion itself is caused by errors in monetary policy. Interest rates are driven down by the Fed, and this causes widespread errors in the investment sector. These investments are unsustainable over the long term. The recession is the time of cleansing out errors and reestablishing economic soundness.
The housing boom and bust is only a symptom of a wider problem. If the economy has indeed fallen into recession, we can know with certainty that recession is precisely what the economy needs the most. It is the equivalent of the drunk who needs time on the wagon.
The rap on the Austrian School of the 1930s is that they counseled a do-nothing policy on the depression. That is not true. There are many things that government can do but they all amount to doing less, which is a positive action of sorts. It must not attempt to prop up and raise wages. It must stop taxing business so heavily and raising the costs of investment. It must cut regulations that are hampering recovery. It can cut spending dramatically as a way of returning resources to the private sector where they can do some good.
What government cannot do without causing even more problems is take positive action against symptoms, such as falling stocks or housing prices, rising unemployment, business failures, and falling incomes. This is precisely what caused the Great Depression to get its name instead of being called what it might have been called: the recession of 1929–1931.