The business cycle creates a disequilibrium in capital which in turn reduces employment. Stimulating demand may only stimulate those capital goods that are already fully employed. Without additional investment, no further job growth will take place.
In any economy, employment is tied to capital goods. Robinson Crusoe may arrive on the island with barely clothes, he still has the island’s natural capital available – that is to say the natural capital is unemployed. By combining his labor with the beach, for example, Crusoe achieves productivity. He extracts fish from the ocean. This productivity is subject to marginal returns in two dimensions: the upper limit of the beach in terms of workers at once, and the individual productivity of each worker.
Supposing that more shipwrecked souls turn up on the island, Crusoe can bring them to work on his beach up to the point where all space is covered. Any additional worker beyond that point will produce no net benefit and must thus remain unemployed. However, because individual productivity also matters to the income produced from the beach, Crusoe will reserve the scarce space only for the best fishers. This means that, as long as there is only one beach, Crusoe might offer wages above the labor market price as to select only the best workers out of the pool. Because of the scarcity of capital, Crusoe will not lower wages no matter how low market wages fall, even if they fall to zero. Submarginal workers must remain unemployed.
In order for the labor market to clear there then must also be free markets for capital, and investment in and the deployment of additional capital goods. Crusoe, as the island’s only capitalist, must take into consideration when deciding to hire additional labor not simply the costs of this labor, which for shipwrecked souls is rather close to zero, but also the costs of capital investment. As the shipwreckees do not have any savings of their own, only Crusoe can provide the savings to invest into new capital with which to employ these workers. He must feed them while they build a farm or some other edifice from which goods will then be produced. How many (or how big) a farm to build depends on the total optimal returns of both capital and labor in combination.
The United States, in the current state of its economy, is a free labor market. Despite this it has achieved a more or less stagnant level of unemployment at 9-10% since the last recession began in 2008. According to neoclassical economic theory, this is impossible. Wages should fall until labor market equilibrium is restored. What has happened in reality has been that a handful of formerly highly productive workers have been thrown out of employment, while the wages of those remaining employed have stayed the same. (A phenomenon Keynesian economists label “sticky wages”.) Even more bizarre has been some firms’ hiring policies of only accepting candidacies from workers who are currently employed, and rejecting those of the unemployed. Surely it would be better for those firms to hire the unemployed at much lower wages? And why is it increasingly difficult for graduates to obtain unpaid internships? Why would any firm refuse free labor? This ignores the current situation of the capital markets, which have not been allowed to recover from the boom/recession. In reality, firms face the same problems as Crusoe did with his limited capital – they must only employ the most productive workers at the highest wages.
Austrian economic cycle theory as developed by Ludwig von Mises states that a recession can only be understood as a reaction against the boom that preceded it. During a boom, the government and its central bank implements a policy of forceful reduction of interest rates. This sends a signal to invest more in higher order capital goods (those that take longer to deploy and thus consume more savings) and less in lower order capital goods. While it may only take a few weeks to build a house, it takes months to years to build a full housing subdivision or residential tower, and producing the equipment necessary to construct them adds even more time to the production cycle. The government’s policy takes capital out of the lower order industries and puts them into the higher-order industries, and thus the labor force of the lower order industries shrinks (while wages remain high or may even climb higher due to the scarcity of capital) while the higher-order industries expand by bidding up the prices of capital goods and workers.
Of course, because the government’s policy of forceful reduction of interest rates is backed by pure inflation, it eventually becomes intolerable for the powers-that-be and it is scaled back. Interest rates are allowed to rise again (this took place in 2006-2007). When this occurs higher order capital goods become uneconomic, no longer justifiable in cost of finance. This means that all the capital goods that were produced to enable their production become useless, unless they can be retrofitted to produce lower-order goods. (This can be the case with trucks, but not construction cranes, for example.) Since those higher-order capital goods are no longer productive, it follows that attached workers also become unproductive at any wage and must become unemployed. And since this change in productivity takes place more or less instantaneously as a consequence of the government’s policy change, what occurs is a sudden and immediate loss in capital over the entire economy. Worse, because the set of capital goods employed in lower-order production shrunk during the boom years, the economy is less productive after the boom than it was before it. However, those workers lucky enough to increase their wages in the lower-order sectors will remain working at these higher wages because the productivity of lower-order capital has not changed, while its scarcity remains high.
In order for any meaningful economic recovery to take place, there must be a process of re-investment in lower-order capital called a liquidation of capital. This implies that capital goods made useless by the change in interest rate policies be sold off to capitalists with enough savings to transform them into lower-order capital goods, and only after enough time and savings have been invested in this can the unemployed workers be put back to work.
The problem as persists in the United States is that the government has followed an anti-capitalist policy for decades that drives away investment to more capitalist-friendly countries such as China, and this anti-capitalist policy was only masked by the inflation of the years 2001-2007. (In fact, it is probable that the inflation was a response to the lower investment that resulted from this policy.) The result is that today capitalists are unwilling to invest in the United States as they see no profitable returns from large capital investments. The CEO of the Intel Corporation, a champion of American High-Tech capitalism during the 1980′s and 1990′s, even made a public plea about American policy making it a billion dollars more expensive to build a factory than its equivalent in China. As a consequence, only the most productive workers remain employed in the shrinking pool of capital. The labor force grows but the supply of capital does not, and so unemployment becomes permanent. Another former Intel CEO despaired that American companies could no longer afford to do anything but the least capital-intensive operations in America, while all their industrial work was being done in gigantic Chinese corporations. This is a problem of capital policy in the United States, and it has been allowed to deteriorate for a generation without a single politician or would-be politician acknowledging that such a problem exists.
The only solution to the recession, or the much wider-in-scope depression that has lasted for a decade and been masked by the real estate bubble and other inflation, is to dramatically reform capital policy, to make capital more secure and less expensive to deploy, to make capitalists’ real savings purchase more capital goods by eliminating interest rate subsidization by bank credit inflation, and to drastically cut into regulatory costs and bureaucracy spreading fear amongst the capitalist class.