Why Keynes Was Wrong About Unemployment

Large-scale unemployment is another name for a surplus in the labor market. Equilibrium is a state which markets will naturally move toward as buyers and sellers look for mutually advantageous exchanges. 

Firms can always get some value from additional labor, even under pessimistic forecasts of sale prices and quantities. Workers earning zero wages can improve their situation by accepting a job—even if they do not accept the first offer. Therefore, a labor market in surplus will absorb unemployed labor at a lower wage. When a market is in surplus, the direction the price must go toward equilibrium is down.

Or so it was thought before Keynes. Keynes’s notion of unemployment equilibrium was a break with prior theory, which held that markets clear through price and quantity adjustments. When there is a surplus, a lower price is needed to clear a greater quantity of employment.

Keynes had two contrary arguments. The first, that wages are inherently stuck at a particular monetary value. It is unclear how this value was arrived at in the first place. It may have been a wage that worked during good times. Keynes’s view is that unemployed workers are unwilling to accept a lower nominal wage than they made at their last job. The second was that even if a lower wage would, at first, employ more workers, the lower wage rate would remove so much purchasing power from the labor force that labor would be unable to purchase the increase in output. Business sales would drop off, business firms would have to lay off the workers, and the market would be back in surplus.

The British-Austrian economist William Harold Hutt identified Keynes’s theory of unemployment equilibrium as the most novel and original aspect of his work. Henry Hazlitt’s second law is the observation that everything in Keynes’s General Theory is either unoriginal or untrue.1 From Hazlitt we know that the unemployment equilibrium doctrine is untrue.2

Hutt was a great but underappreciated critic of Keynes. His critique of the New Economics was rooted in two foundations: the first, Say’s law; the second, an appreciation of how a functioning market price system can integrate all useful services into productive use. Hutt took on both of Keynes’s arguments with a powerful rebuttal. Against the claim of wage rigidity, he argued that, to the extent that wages are rigid downward, this was not a natural feature of labor markets. Workers can and do adjust to changes in the demand for their services, not only by accepting lower wages when that is their best option, but also by moving around to better opportunities. This can be a better wage doing the same thing or a change to an industry or line of work where better opportunities lie. The wage rigidity that was a crucial plank of the unemployment doctrine was a particular characteristic of the British economy at the time. The problem had come about due to labor union coercion, which prevented a free labor market from operating. Hutt also drew attention to incentive payments for not working, such as unemployment insurance, which discouraged workers from accepting a wage that businesses were willing to offer. The Babylon Bee explained the same problem in a piece called “Shocking Study Finds Paying People Not to Work Makes People Not Want to Work.”

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