F. A. Hayek, Inflation, the Misdirection of Labour, and Unemployment

This 2022 republication presents Hayek’s lecture delivered in Rome on 8 February 1975, with editorial notes documenting its revised 1975 publication and 1976 proceedings version. Addressing the end of the post-war “Great Prosperity,” Hayek argues that inflationary employment policy creates an increasingly unstable distribution of labour. Unemployment following monetary stabilisation exposes these accumulated distortions rather than demonstrating an inherent failure of the market. The lecture moves from the historical origins of Keynesian policy through a critique of aggregate-demand explanations to the institutional conditions and practical difficulties of restoring stable money.

Hayek opens with a constrained choice: accelerating inflation, controls that conceal inflation while extending central direction, or monetary restraint that reveals unsustainable employment. His central contention reverses the familiar comparison between inflation’s distributive costs and unemployment’s lost output:

The argument often advanced that inflation produces merely a redistribution of the social product while unemployment reduces it and for this reason represents a greater evil is thus false, because inflation becomes the cause of increased unemployment.

The historical discussion distinguishes the lessons of Austrian and German inflation from Britain’s exceptional interwar circumstances. The former showed that inflation-created employment disappeared when inflation slowed. Britain, by contrast, restored sterling’s pre-war gold parity in 1925, necessitating deflation after an appreciation that had raised real wages relative to international competitors. Hayek approves returning to gold but criticises the parity chosen. He reads Keynes’s development against this particular predicament: reducing real wages initially appeared necessary, then politically impossible, and finally economically misguided. Hayek nevertheless suggests that Keynes himself might have opposed his followers’ post-war inflationism.

The decisive conceptual move is from total demand to the composition of demand. Hayek locates unemployment in a mismatch between the distribution of labour across industries and localities and demand for their products. Correction therefore requires changes in relative prices and wages, not simply additional expenditure. This explanation also grounds his criticism of statistical standards of proof:

Causes may, however, be very effective although not measurable, and the current superstition that only the measurable can be important has done much to mislead us.

Because the equilibrium configuration of prices and wages cannot be known beforehand, deviations from it cannot be measured directly. Aggregate-demand theory, Hayek argues, gains an unwarranted advantage because its variables permit statistical testing. He treats this as a methodological bias rather than evidence that sectoral maladjustment is unimportant. The lecture thus connects the employment controversy to his broader objection to identifying economic knowledge with measurable aggregates.

Political incentives reinforce this intellectual preference. Deficit spending promises an apparently inexpensive remedy for suffering while relaxing constraints on governments seeking popularity. Hayek interprets Bretton Woods’ emphasis on expansion by surplus countries, followed by the abandonment of fixed exchange rates, as successive losses of monetary discipline. Fixed rates matter chiefly as an external compulsion that allows politicians to resist demands for cheap credit and expenditure. Domestic price increases provide a slower warning, often arriving after employment gains have made expansion attractive. He acknowledges that Germany and Switzerland had reasons to abandon a collapsing system, while maintaining that international stability ultimately requires effective external constraints.

The mechanism of misdirection combines uneven monetary flows with expectations of further price increases. Expansion changes relative demand across sectors and stages of production, drawing workers into jobs whose profitability depends on continued inflation. Government guarantees of full employment also weaken unions’ incentives to consider the employment consequences of wage demands: increases exceeding productivity then invite further monetary accommodation.

The chief point I want to bring out is that the longer the inflation lasts, the greater will be the number of the workers whose jobs depend on a continuation of the inflation, often even on a continuing acceleration of the rate of inflation—not because they would not have found employment without the inflation, but because they were drawn by the inflation into temporarily attractive jobs which after a slowing down or cessation of the inflation will again disappear.

The distinction is between employment that could have existed under stable conditions and the particular jobs expansion has induced. Maintaining those jobs postpones adjustment while enlarging its eventual costs. Indexation may alleviate some consequences of inflation, but cannot correct this allocation problem.

Hayek’s policy conclusion is qualified more carefully than his opening polemic might suggest. He rejects creating unemployment as an anti-inflationary instrument: his claimed choice is between unemployment soon and greater unemployment later. Money growth should stop, or fall to the rate of real production growth, without unnecessary delay. Yet stabilisation must not become an uncontrolled contraction:

If I were today responsible for the monetary policy of a country I would certainly endeavour to prevent a threatening actual deflation, that is an absolute decrease of the stream of incomes, with all suitable means, and would announce that I intend to do so.

He explicitly abandons his earlier practical hope that deflation could break downward wage rigidity. “Secondary deflation” can deepen recession without performing a useful reallocative function. Preventing it does not remove the need to restructure relative prices and wages; Hayek declines to predict how quickly that adjustment can occur.

The long-run objective is sustainable employment rather than its short-run monetary maximum. Hayek favours automatic monetary restraints but questions Friedman’s rigid money-growth rule because money and near-money lack a sharp boundary and liquidity protection requires discretion. He likewise admires gold-standard discipline while doubting governments would honour its international rules. The closing signs of British policy reconsideration are tempered by editorial notes correcting quotations and contextualising Denis Healey’s remarks within the Labour government’s social contract. The lecture’s enduring significance lies in combining an allocation-based critique of inflationary employment policy with an explicit commitment to preventing a destabilising collapse of incomes.