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.


  1. Hello Inquisitor. An example relating, again, to the housing bubble were the number of investments in housing developments both prior to their completion and prior to their end-customer sale or end-customer lease. If we take a look simply at housing with development being a higher order good and, finally, accomodation being the lower-order good, then we notice in Florida, Arizona, Nevada, etc a great many investments at the development phase. Regular folk were speculating and flipping before a house even had its foundations laid (the foundations itself a higher-order good). Often, homes were flipped multiple times before completion of constuction. There is significant data available on this trend prior to the collapse.

    • I can get that glib answer from Krugman.

      If you are right, then it shouldn’t be hard to show some empirical data at the micro level. Where is that analysis?

      • Look at what happened in the 1920s. The Federal Reserve created an artificial boom that led to bust in 1929. Or look at the last decade. A lowering of interest rates and cheap credit creation by the Fed made investment seem lucrative when actually such investments were malinvestments. Unsustainable boom goes bust; the economy is in the crapper. What do you mean on a micro level? This is a macroeconomic analysis. I suppose I could find charts or graphs or tables. I will send you to to get the best analysis on this subject.

  2. The current unemployment is structural in a Hayekian sense – its root is significant misdirection of production.

    Do we have empirical evidence that shows this misdirection? I understand the ABCT, but I’d like to see some data showing this shift over the past decade or two.

    Those who call for more “aggregate demand” point to lags in actual vs. potential GDP. I’d like to see the ABCT story expressed in data showing the misallocation of resources from one industry to another or from one stage of production to another.


    • One book I recommend looking at is Jeffrey Friedman’s and Wladimir Kraus’ Engineering the Financial Crisis. While the book is not Austrian, nor do either author adopt the Austrian theory of business cycles, I do think that the book is highly compatible with the Austrian theory. It is not an economy-wide look at the recession, but it does look at one obvious area of malinvestment: the housing market.

      Admittedly, they blame an overconcentration of investments, by part of investment banks, in mortgage backed securities on regulations (the recourse rule, to be specific). But, the book doesn’t really address the root of the issue, and I think this is where it is very open to interpretation.

      The recourse rule, based on (if I remember correctly the Basel II package, was a guide that regulated banks’ capital reserves in relation to the perceived riskiness of owned assets. The key part is that mortgage backed securities were given high ratings (AAA), since they were perceived to be relatively non-risky, and therefore banks concentrated investments there.

      The book does a poor job of explaining why rating agencies did such a bad job at really assessing the risks of different assets. The authors, following a paper by Lawrence H. White in Critical Review, blame cartelization between three major rating agencies: Moody’s, Standard & Poor’s, and Fitch. The authors cite one example of smaller rating agencies recognizing the true risk of holding mortgage backed assets; but, one example is not enough.

      This is where the story is open to interpretation. Why did rating agencies do such a poor job? The Austrian explanation is price distortion — and, how is a rating agency supposed to know the “true” price. There is a reason why these assets were perceived as low-risk and low-earning; it is because given prices, at the time, these assessments made sense. It was when the pricing process suddenly reverted that these ratings were shown to be poor.

      Finally, while the name escapes my memory right now, there is also an article for the Quarterly Journal of Economics that commits to a relatively brief empirical analysis of Austrian business cycle theory. That is, it tries to find historical data related to this most recent recession to show that the Austrian theory does apply.

    • What evidence are you after? Do you want evidence to the effect that the conditions necessary for the theory to be operative are in place, i..e price controlling of interest rates via credit expansion? Or historical trends? Or what?

      Businesses are very shy of hiring at the moment both due to a barrage of new regulations coming at them from every direction but also because a lot of investments during the crisis were revealed to be poorly chosen. GDP isn’t a very meaningful or interesting figure for analysing economies. The current bloated size of the financial industry and the vast proportions the construction and housing-related industries assumed are evidence – or rather, examples – of resource misallocation caused by artificially low interest rates and regulations/trends that helped funnel money into those particular markets.

      • The ABCT says that inflationary monetary policy misdirects the structure of production through malinvestments. Those malinvestments should show up at the micro level. What I am asking is to show that micro-level distortion.

        If real resources are shifted from later stages to earlier stages we should be able to see that by comparing companies/industries in those various stages. Shouldn’t we be able to see changes in employment levels, profitability, or capital accumulation? Or something?

        The current bloated size of the financial industry and the vast proportions the construction and housing-related industries assumed are evidence – or rather, examples – of resource misallocation

        Bloated as compared to what, though? Large financial and construction industries are not necessarily bad.

        I like the ABCT, I think it tells a good story. I just want the Austrians to pound that story home with empirical data.

        I will give credit to Bob Higgs and Bob Murphy, though. In the past they have done some of this analysis. I just don’t see much of it anymore. But I see other schools using empirical data to tell bad stories.

      • “If real resources are shifted from later stages to earlier stages we should be able to see that by comparing companies/industries in those various stages. Shouldn’t we be able to see changes in employment levels, profitability, or capital accumulation? Or something?”

        Yes, hence why I referred to the construction and financial industries. The latter has been injected with bailout funds etc. to keep it afloat but the former has been faltering, particularly in Europe in countries like Spain. I suppose I see your point in that other schools spin out a lot of bullshit that needs to be debunked. It’s very easy to utilise misleading figures like GDP and job “creation” figures and pretend everything is going well.

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