DEPARTMENT OF ECONOMICS

LABOR ECONOMICS FROM AN AUSTRIAN PERSPECTIVE

PETER J. BOETTKE
AND

WILLIAM J. LUTHER

George Mason University Department of Economics Working Paper No. 12-41

Labor Economics from an Austrian 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 in labor economics. We briefly review the history and methodology of the Austrian school and describe major contributions to labor economics from those working in the Austrian tradition. Then, we offer a sketch of the Austrian theory of labor markets and discuss its implications. In doing so, we hope to have helped the interested reader along 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: pboettke@gmu.edu Address: Department of Economics, George Mason University, MSN 3G4, Fairfax, VA 22030 Phone: 703.993.1149

Email: lutherw@kenyon.edu Address: Department of Economics, Kenyon College, Ascension Hall #305, Gambier, OH 43022 Phone: 740.222.1242

Electronic copy available at: http://ssrn.com/abstract=2130999

Austrian Labor 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 of Anna Schwartz. For a concise review of the differences between Austrian and Monetarist perspectives, see Garrison (2006).

2
Electronic copy available at: http://ssrn.com/abstract=2130999

Austrian Labor 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 Jean2

The historian Tom Woodss (2009) also takes the Austrian position.

Austrian Labor 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 4

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

Austrian Labor 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 6

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

Austrian Labor 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 foregone opportunities. 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

Austrian Labor 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 separate actions 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 members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodityor rather that local prices are connected in a manner determined by the cost of transport, etc.brings about the solution which (it is just conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process.

Austrian Labor 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 activity of 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?

Austrian Labor 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 traditional Austrians 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 discuss the prospect of synthesizing Austrian and Public Choice approaches. See also: Boettke and Lopez (2002), Ikeda (2003), and Boettke (2012, chapters 4; 8-11; 17).

Austrian Labor 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 seriously grapple 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 threevolume 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, BhmBawerk 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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Austrian Labor 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 political economy 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, BhmBawerk 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 of Marx in the Quarterly Journal of Economicscites Bhm-Bawerks work as the point of view of classical economics.

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Austrian Labor 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 the entrepreneurs intent upon making profits. Each entrepreneur is eager to buy all the 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 from competing entrepreneurs. The upper limit of his bidding is determined by anticipation of the price he can obtain for the increment in salable goods he expects from the employment of the worker concerned. The lower limit is determined by the bids of competing entrepreneurs who themselves are guided by analogous considerations. It is this that economists have in mind in asserting that the 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 are determined by the supply of labor and of material factors of production on the one hand 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 sociological characteristics.

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Austrian Labor these two characteristicsheterogeneous labor and a price maker model of the competitive market processcontinue to inform the Austrian conception of labor economics today. Having reaffirmed the marginalist conclusions, albeit on his own terms, Mises then analyzes the economic effects of labor unions. In particular, he highlights their insider-outsider nature. It is an undeniable fact that there prevails an irreconcilable conflict of interests between those workers who are employed at union wage rates and those who remain unemployed because the enforcement of union rates prevents the demand for and the supply of labor from finding the appropriate price for meeting (p. 80). Indeed, Mises (p. 374) claims harming non-union labor is the logical (if not stated) intent of union organizers: On the domestic market the unions do not tolerate the competition of nonunionized workers and admit only a restricted number to union membership. Those not admitted must go into less remunerative jobs or must remain unemployed. The unions are not interested in the fate of these people. The belief that union organizers could truly be interested in the welfare of all laborers, to Mises, seemed untenable, as did their view that capitalism has a tendency to impoverish the worker. The truth, Mises (p. 612) writes, is that capitalism has poured a horn of plenty upon the masses of wage earners who frequently did all they could to sabotage the adoption of those innovations which render their life more agreeable. Though largely outside the domain of labor economics at the timeboth because of the prevailing union-centric state of labor economics and its somewhat unique emphasis on physical capitalthe theory of business cycles developed by Mises (1919) and Hayek (1929, 1931) also deserves some attention. The authors claim unsustainable economic booms result when the prevailing rate of interest falls below the natural rate,

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Austrian Labor 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 malinvestmentis 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

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

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Austrian Labor 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 differencein-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 inmigration and out-migration. Assuming homogenous labor, many observers were puzzled that migration from the low-wage South was largely offset by migration from the highwage 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 states considered, and (3) restricting analysis to too narrow a time period. To overcome the perceived shortcomings of the original study, the authors consider (1) the entire food and drink industry, (2) the difference between Pennsylvania and New York (since both are outside the purview of the New Jersey minimum 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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Austrian Labor 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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Austrian Labor 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, capture any 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-costreducing 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 of substitution between wage and fringe benefits, different levels of skill, and they differ in their willingness to 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 monitoring efforts of the principals. The principal-agent problem becomes a many principal-agent problem.

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Austrian Labor 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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Austrian Labor 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 sector experiences 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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Austrian Labor 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 of adoption 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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Austrian Labor 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 facilitates comparisons 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 ! = w1 + w2 ! " (n1 + n2 ) , where n1, n2 and w1, w2 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 economics are similar to the equilibrium construct used by Mises (1949); but whereas Mises used a frictionless model as a foil, modern authors attempt to imbed specific frictions into the model. See also: Luther (2012b).

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Austrian Labor 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 nd themselves 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 selfascribed Austrian economists (Peter Lewin and Walter Block) earned their advanced degrees under Gary Becker.

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Austrian Labor 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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Austrian Labor 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.

Devise Plan

Secure Resources

Produce Good

Deliver Good

Losses

Experience Prots

Normal Return

Figure 1 The Entrepreneurial Production Process

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

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Austrian Labor 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.

Devise Plan

Invest in Human Capital

Seek Employment

Losses

Work

Experience Prots

Normal Return

Figure 2 The Entrepreneurial Worker

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

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Austrian Labor 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 in mind. 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-ofequilibrium 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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Austrian Labor 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-anderror 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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Austrian Labor 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. Disequilibrium dynamics 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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Austrian Labor 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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Austrian Labor 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 might more-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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Austrian Labor 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 selfemployed. 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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Austrian Labor 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 actually employed, 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 unemployment corresponds to the natural rate of unemployment, which mainstream economists commonly divide into structural and frictional unemployment. Since, from an Austrian perspective, all unemployment has a structural component and since Mises (1949, p. 597-8) believed the term frictional was inappropriate, we avoid using both terms.

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Austrian Labor 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 what follows, 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, Zijp and Visser (1994), Butos (1997) and the citations contained therein. Although these articles compare and contrast 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 dispute the existence of Cantillion effects. However, the topic is well beyond the scope of this paper and would add unnecessary 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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Austrian Labor

Final Goods

Early Stages

Late Stages

Stages of Production
Figure 3 The Hayekian Triangle

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., including unnecessary steps). Nonetheless, the output of those processes actually employed is positively correlated with the length of the production process since it is not in the interest of entrepreneurs to employ a less efficient production process.

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Austrian Labor (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 SLF reflects the amount of funds savers desire to lend at various interest rates. The demand curve DLF 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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Austrian Labor

Hayekian Triangle
Consumption Final Goods

Production Possibilities Frontier

Stages of Production

Investment

Interest Rate

SLF

i*

DLF

S=I

Savings, Investment

Market for Loanable Funds

Figure 4 The Austrian Macro Model

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Austrian Labor 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 can move 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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Austrian Labor 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 SLF to SLF + m. Since it does not constitute a genuine increase in savings, but rather an increase in money, the new supply curve SLF + m is depicted with a dashed line. Market participants respond to the perceived increase in savings by bidding down 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, SLF; 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 SLF + 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 consumptioninvestment 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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Austrian Labor 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 their respective effects on these stages of production. First, the lower interest rate has a time discount effectthat 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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Austrian Labor

Stages of Production

Consumption

Interest Rate

Final Goods

Investment

SLF SLF + m

i* i

DLF

Savings, Investment

Figure 5 Austrian Business Cycle

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Austrian Labor the real resource constraint is realized, the boom turns to bust. And since resources have been malinvestedredirected to the wrong stages of productiona reallocation period takes place wherein output falls to a point inside the original production possibilities frontier.

Final Goods

Early Stages

Intermediate Stages

Late Stages

Stages of Production
Figure 6 The Distorted Hayekian Triangle

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

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Austrian Labor 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 up wages 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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Austrian Labor 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 person will look longer. Wage earning opportunities will diminish in the sense that lower wages are available elsewhere. People use time to learn that the failure to find other equally good job options as quickly as they thought they would, reflects diminished alternatives in general, not unlucky search. The discerned maximum offers will be lower than if the structure of alternatives had not decreased. The lower level and slower rate of rise of best observed options is at first taken as an unlucky string of searches, and so unemployment is extended in the expectation of shortly finding that elusive best option. And with each person looking longer the total number of unemployed at any one time will be larger. (Incomes fall and feedback effect occurs.) Each now has the added task of revising his whole pattern of expectations. Whereas he was formerly searching for a higher clearly formulated 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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Austrian Labor 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 Austrians generally 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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Austrian Labor 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 the underlying 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 longterm 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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Austrian Labor 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 candidateperhaps opting 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 exhausted by other firms. As mentioned above, in Section 1.2, Austrian considerations of the capital structure have historically focused on physical capital. This need not be the case. Human capital is also specific and some investments in human capital cannot be undone. Furthermore, deciding how much human capital to acquire depends, at least in part, on the interest rate. So we should expect human capital decision to be distorted over the business cycle in much the same way as physical capital (i.e., gaining human capital compatible with early and late stage production processes in the boom). Although Austrians could do more to integrate human capital into the Austrian business cycle theory, it is not as foreign a concept as it perhaps once was. 3. Implications

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Austrian Labor The Austrian view of labor markets, which emphasizes entrepreneurship, heterogeneity, individual decision-making, and the decentralized nature of knowledge, yields several interesting implications, some of which have already been mentioned above. We list and discuss what we believe are the five most important.

1. Some (measured) unemployment is desirable. A dynamic market process requires resources be reallocated when the underlying fundamentals of the economy change. Some resources will be unemployed during the reallocation process. For example, a worker might take off time to retrain or relocate. Unemployment arising in the context of the dynamic market process is desirable: it facilitates the reallocation of resources to higher valued uses. Hence, policy makers should not strive for full employment (i.e., zero unemployment). Full employment policies, if effective, make individuals worse off. Policies that coerce individuals to work at a less-than-agreeable wage (e.g., conscription into the armed services) reduce welfare by producing goods (1) worth less than the value of their inputs or (2) at a higher cost than is necessary. Policies that temporarily confuse workers into thinking the prevailing wage is desirable when, in fact, it is less-than-agreeable (e.g., during the early stages of unexpected monetary expansion) temporarily push the economy beyond the sustainable level of production. In doing so, such policies generate a boom-bust cycle and necessitate a painful reallocation process. Rather than trying to reduce unemployment to zero, the institutional environment should facilitate economic activity consistent with the natural rate of unemployment and output.

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Austrian Labor 2. Interfering with the market process creates additional (undesirable) unemployment. Although some unemployment is desirable, laws preventing workers and employers from agreeing to mutually beneficial employment terms (e.g., minimum wage requirements, compulsory union membership, occupational licensing) increase the natural rate of unemployment beyond the desirable level. These policies make the average individual worse off by restricting potential gains from trade.

3. Austrian business cycles result in vertical and horizontal changes in employment. Austrians tend to emphasize distortions in the structure of production stemming from unexpected monetary expansion, whereby some workers (and capital) are drawn to particular stages of the production function. These horizontal changes are ultimately unsustainable and result in a necessary period of reallocation. However, the Austrian business cycle theory is also consistent with vertical changes in employmentthat is, the increase and decrease in aggregate employment commonly observed over the business cycle.

4. Short-run fiscal policy is largely ineffective and potentially destabilizing. The Austrian view of labor markets suggests fiscal stimulus programs are largely undesirable. Consider, for example, temporary government spending projects, retraining programs, and tax cuts. Temporary government spending projectsto the extent they are effectivepull resources (labor and capital) into short-term projects by design. In doing so, they distort the natural reallocation process Austrians claim is essential. Government sponsored retraining programspopular under the Clinton administrationsubsidize

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Austrian Labor particular human capital investments relative to others. Austrians doubt that government bureaucrats have better information than individual workers as to which skills are most needed in the economy. They also question the incentives of bureaucrats charged to make such decisions. Tax Cutsif not accompanied by spending cutsrequire future tax increases or monetization of debt when the bill ultimately comes due.29 Combining tax and spending cuts might be desirable if the private sector is more efficient than the public sector on the margin, though there is no need to wait for a recession to experience these gains. Austrians therefore maintain that the level of taxation should be sufficient to cover expensesno more, no less. Austrians fear adjusting taxes in an effort to fine-tune the business cycle increases uncertainty, making it more difficult for entrepreneurs to reallocate resources to higher valued uses.

5. The monetary system should be designed so as to avoid boom-bust cycles; monetary policy should be predictable. If monetary expansion is the primary cause of welfare-reducing boom-bust cycles, individuals might better be served by some alternative monetary system that constrains such outcomes from ever occurring. Austrians commonly advocate a gold standard and/or free banking. Some Austrians restrict the former to a 100 percent reserve system. Other Austrians often (but not always) assume the latter (wherein banks issue their own redeemable banknotes) is backed by gold. We will not go into the details of these systems here, but suffice it to say that Austrians support these systems primarily on the grounds that they will be less likely to generate boom-bust cycles than the status quo.

29

Tax cuts might be helpful in the case where the government consistently runs a budget surplus. However, public choice pressures make such a scenario unlikely in practice.

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Austrian Labor If alternative monetary systems were off the table, Austrians would prefer rulebased to discretionary monetary policy since fixed rules make it easier to predict the future and thereby reduce the level of uncertainty entrepreneurs must deal with. Which rule do Austrians prefer? There is a fair amount of disagreement on the question. Some Austrians argue for strict adherence to a nominal income target or Taylor rule. Others doubt whether central banks can be constrained to follow such rules, and opt instead for rules that are easier to understand (and, hence, easier to enforce) but less effective at mitigating business cycles; examples include fixing the money supply or requiring that it grows at a fixed percent each year. The disagreement largely centers on whether the social losses from a good rule that is not always followed are greater or than those stemming from a bad rule that is more often followed, where good and bad denote how effective a rule is at mitigating undesirable aggregate economic fluctuation when the rule is actually followed. 4. Conclusion 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 in labor economics. Having briefly reviewed the history and methodology of the Austrian school, described major contributions to labor economics from those working in the Austrian tradition, offered a sketch of the Austrian theory of labor markets, and discussed the implications of the Austrian view, we hope to have helped the interested reader along both lines.

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Austrian Labor So what does Austrian economics have to say about the jobless recovery? Real time analysis is always a bit tricky, but we think several Austrian contributions can be of use today. The need to reallocate labor after the housing bubble burst no doubt explains some of the observed unemployment. Moving forward, it would be desirable to adopt a monetary system or monetary rule (if the system cannot be changed) that prevents boombust cycles of the type recently experienced. Moreover, some unemployment might be explained by an increase in uncertainty. The policy environment has been anything but stable over the last few years. Entrepreneurs first had to anticipate whether and to what extent Congress would intervene in terms of fiscal stimulus and new regulation. Then they had to gauge if and when the particular efforts decided upon would be put into action. Even today, much uncertainty remains concerning the future taxes, regulation, and spending projects (especially entitlement programs). Even if such measures were introduced with good intentions, the net impact has been to distort the economy, prolong the recovery, and reduce potential gains from trade. Until such matters are shored up, we expect more of the same in the labor market. References Alchian, Armen A. 1950. Uncertainty, Evolution, and Economic Theory. Journal of Political Economy, 58(3): 211-221. Alchian, Armen A. 1969. Information Costs, Pricing, and Resource Unemployment. Western Economic Journal, 7(2): 109-28. Backhouse, Roger E. 2000. Austrian Economics and the Mainstream: View from the Boundary. Quarterly Journal of Austrian Economics, 3(2): 31-43. Becker, Gary S. 1957. The Economics of Discrimination. Chicago: University of Chicago. Bellante, Don. 1979. The North-South Differential and the Migration of Heterogeneous Labor. American Economic Review, 69(1): 166-75. Bellante, Don. 1983. A Subjectivist Essay on Modern Labor Economics. Managerial and Decision Economics, 4(4): 234-43.

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