A Keynesian who rejects the Austrian theory of the business cycle is no more credible than an alcoholic who doesn’t believe in hangovers or a rocket scientist who doesn’t believe in gravity:
A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the “Austrian theory” of the business cycle—a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire. Oh well. But the incident set me thinking—not so much about that particular theory as about the general worldview behind it. Call it the overinvestment theory of recessions, or “liquidationism,” or just call it the “hangover theory.” It is the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion.
Is there anything more foolish than responding to an inquiry about your own inadequacies than making a naked appeal to your own authority? Paul Krugman isn’t just an intellectual coward afraid to engage his critics, in this essay he shows that he’s an unmitigated ass to boot. The idea that Austrian theory isn’t worthy of serious study was remarkably stupid in 1998; it’s arguably insane now that not one, not two, but THREE credit inflation-induced “hangovers” have occurred since then. One could make a much more reasonable case that Keynesian theory is only worthy of serious study in sense that a flight recorder demands intense examination after an airplane crash. It would also be interesting to see if Krugman would describe gravity in a similarly perjorative fashion: the damage an object suffers in falling to earth being the “necessary punishment” for having been projected aloft. AGDers will note that Krugman’s incorrect terminology is precisely what Rothbard predicted of Keynesian critics 25 years before:
“Overinvestment” or Malinvestment? The second misconception, given currency by Haberler in his famous Prosperity and Depression, calls the Misesian picture of the boom an “overinvestment” theory.
– Murray Rothbard, America’s Great Depression, p. 30.
The hangover theory is perversely seductive—not because it offers an easy way out, but because it doesn’t. It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love. Powerful as these seductions may be, they must be resisted—for the hangover theory is disastrously wrongheaded. Recessions are not necessary consequences of booms. They can and should be fought, not with austerity but with liberality—with policies that encourage people to spend more, not less. Nor is this merely an academic argument: The hangover theory can do real harm. Liquidationist views played an important role in the spread of the Great Depression—with Austrian theorists such as Friedrich von Hayek and Joseph Schumpeter strenuously arguing, in the very depths of that depression, against any attempt to restore “sham” prosperity by expanding credit and the money supply. And these same views are doing their bit to inhibit recovery in the world’s depressed economies at this very moment.
Krugman is frantically waving a red herring about by attempting to bring morality into the discussion. But morality has absolutely nothing to do with the accuracy or inaccuracy of the Austrian model; it simply doesn’t enter into the equation. And the strange frequency with which economic recessions follow expansions can no more be blithely wished away than the consequences of gravity. As Rothbard pointed out, Keynesians like Krugman have no rational explanation for the observable fact that busts do follow booms, which is why their witch-doctoring and appeal to “animal spirits” and “consumer confidence” are so hopelessly ineffective. Krugman is also factually wrong about the effect of “Liquidationist views” in bringing about the Great Depression, as the following statement on the matter conclusively demonstrates that the liquidationist position was uniformly rejected by the pro-intervention financial and monetary authorities in power at the time:
“[W]e might have done nothing. That would have been utter ruin. Instead we met the situation with proposals to private business and to Congress of the most gigantic program of economic defense and counterattack ever evolved in the history of the Republic. We put it into action. . . . We determined that we would not follow the advice of the bitter-end liquidationists and see the whole body of debtors of the United States brought to bankruptcy and the savings of our people brought to destruction.
– Herbert Hoover, 1932
While Joseph Schumpeter was both an Austrian national and an economist, he is generally not numbered among the economists of the Austrian School. Krugman’s mention of Schumpeter rather than Mises, Bohm-Bawehrk, Ropke, or Rothbard indicates that he knows next to nothing of the theory he is attempting to critize. And how, one wonders, can the views held by proponents of the Austrian school, precisely none of whom are holding any positions of political influence and power of the sort currently held by Monetarists and Neo-Keynesians, possibly be blamed for the very ills of which they have been warning everyone for more than a decade, especially by a prize member of the economic elite who, at the time of this essay’s writing, was still seven years from recognizing the existence of the housing boom… and subsequent bust.
The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand. Maybe excessive money creation or reckless bank lending drives it, maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. Whatever the reason, all that investment leads to the creation of too much capacity—of factories that cannot find markets, of office buildings that cannot find tenants. Since construction projects take time to complete, however, the boom can proceed for a while before its unsoundness becomes apparent. Eventually, however, reality strikes—investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover.
As every AGDer knows, the investment boom does not get out of hand for some mysterious, unknowable reason, it gets out of hand due to credit inflation caused by the central bank. Amazingly enough, a survey of the Federal Reserve’s actions between 1998 and 2008 will show that the bank engaged in a tremendous amount of credit inflation, subsequently followed by the investment boom in housing. I note that the historic boom in housing prices was followed by the very economic hangover that the Austrians predict, and which Krugman is mocking here.
Except for that last bit about the virtues of recessions, this is not a bad story about investment cycles. Anyone who has watched the ups and downs of, say, Boston’s real estate market over the past 20 years can tell you that episodes in which overoptimism and overbuilding are followed by a bleary-eyed morning after are very much a part of real life. But let’s ask a seemingly silly question: Why should the ups and downs of investment demand lead to ups and downs in the economy as a whole? Don’t say that it’s obvious—although investment cycles clearly are associated with economywide recessions and recoveries in practice, a theory is supposed to explain observed correlations, not just assume them. And in fact the key to the Keynesian revolution in economic thought—a revolution that made hangover theory in general and Austrian theory in particular as obsolete as epicycles—was John Maynard Keynes’ realization that the crucial question was not why investment demand sometimes declines, but why such declines cause the whole economy to slump.
Krugman is turning the facts upside-down here vis-a-vis the explanations offered by the competing economic models. Austrian theory articulates a very clear answer to why the whole economy slumps. The misallocation of investment resources due to credit inflation means that goods are being produced that consumers neither want nor need. This, combined with price increases that increasingly put goods out of reach of those who are not the beneficiaries of inflation, causes the demand gap that so concerns Krugman. It’s a concrete explanation and much more empirically demonstrable than the mysterious disappearance of consumer confidence that the Keynesians blame, and is directly connected to other observably causal factors such as the interest rate cuts. Krugman is either playing dumb or is genuinely ignorant of how the Austrian school answers these questions.
Here’s the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn’t that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?
Krugman here makes the error that Joseph Schumpeter dismissed as “the Ricardian vice”, freezing all but a few variables in order to pose a false dichotomy. This artificial dilemma is punctured by the obvious fact that not every good produced must be sold; like most Keynesians, Krugman gets hung up on the inability of the Keynesian model to properly account for time-preferences or savings. If someone doesn’t buy a stock or put his cash in a money-market fund, that doesn’t mean he must have bought a lawnmower. And why should there be a rise in unemployment? Because when there is a credit-inflated boom that results in you working at a job producing goods that no one wants, needs, or can obtain financing for, and your employer cannot sell those goods, neither you nor your co-workers are going to be employed in the near future. In their myopic focus on the aggregate picture, the Keynesians constantly forget that inflation, investment, and unemployment all have a disparate impact on different areas of the economy, and those diverse impacts eventually have a cumulative effect on the aggregate.
Most modern hangover theorists probably don’t even realize this is a problem for their story. Nor did those supposedly deep Austrian theorists answer the riddle. The best that von Hayek or Schumpeter could come up with was the vague suggestion that unemployment was a frictional problem created as the economy transferred workers from a bloated investment goods sector back to the production of consumer goods. (Hence their opposition to any attempt to increase demand: This would leave “part of the work of depression undone,” since mass unemployment was part of the process of “adapting the structure of production.”) But in that case, why doesn’t the investment boom—which presumably requires a transfer of workers in the opposite direction—also generate mass unemployment? And anyway, this story bears little resemblance to what actually happens in a recession, when every industry—not just the investment sector—normally contracts.
Because he doesn’t understand what Austrian theory actually teaches, Krugman creates a nonsensical strawman which, as he himself notes, bears little resemblance to what happens in a recession. His error stems his failure to understand that the Austrian concept of an investment boom has nothing to do with workers being employed in the investment goods sector per se; an investment boom merely means that credit-inflated investment is disproportionately directed to a specific sector of the economy which can be either investment goods or consumer goods. Hence the 1996 investment boom in the stock market (investment goods) and the 2003 investment boom in housing (consumer goods).
As is so often the case in economics (or for that matter in any intellectual endeavor), the explanation of how recessions can happen, though arrived at only after an epic intellectual journey, turns out to be extremely simple. A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time. Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it’s not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?
Because the problem is not that people want to hold more money than there is in circulation, the problem is that no one wants, or can afford, the goods that are being produced. All productive capacity is not created equal; the fact that it is available does not make it “perfectly good”. What use is GM’s “perfectly good productive capacity” today, when so few people want to buy GM cars? Again, the focus on the macroeconomic aggregate blinds the Keynesian to the obvious and observable material fact.
The hangover theory, then, turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present. Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives, who can’t stand the thought that positive action by governments (let alone—horrors!—printing money) can ever be a good idea. Some libertarians extol the Austrian theory, not because they have really thought that theory through, but because they feel the need for some prestigious alternative to the perceived statist implications of Keynesianism. And some people probably are attracted to Austrianism because they imagine that it devalues the intellectual pretensions of economics professors. But moderates and liberals are not immune to the theory’s seductive charms—especially when it gives them a chance to lecture others on their failings.
As I already pointed out, numerous Austrians have “managed to explain why bad investments in the past require the unemployment of good workers in the present”. Bad investments in Detroit’s auto-making capacity in the past means that Detroit workers have to lose their jobs now. It’s really not a difficult concept; even a Nobel Prize-winner should be able to grasp it. The fact that Paul Krugman demonstrably does not understand the basic fundamentals of Austrian theory does not make the theory “intellectually incoherent”. Instead, it tends to explain the man’s dependable incoherency on a wide range of political and economic topics. The idea of any Keynesian, with their shamanistic belief in “animal spirits”, criticizing any economic theory as “intellectually incoherent” is downright risible. And the fact that the Keynesian model has so many historical and logical failings to explain away should be Krugman’s first clue that that perhaps it would be worth listening to a lecture or two on them.
Few Western commentators have resisted the temptation to turn Asia’s economic woes into an occasion for moralizing on the region’s past sins. How many articles have you read blaming Japan’s current malaise on the excesses of the “bubble economy” of the 1980s—even though that bubble burst almost a decade ago? How many editorials have you seen warning that credit expansion in Korea or Malaysia is a terrible idea, because after all it was excessive credit expansion that created the problem in the first place?
Plenty, these days. Krugman himself has written on it, as a matter of fact. Austrian theory was warning about the dangers of credit expansion long before the Japanese, Koreans, and Malaysians began slashing their interest rates; again Krugman only manages to demonstrate his near-complete ignorance of the literature.
And the Asians—the Japanese in particular—take such strictures seriously. One often hears that Japan is adrift because its politicians refuse to make hard choices, to take on vested interests. The truth is that the Japanese have been remarkably willing to make hard choices, such as raising taxes sharply in 1997. Indeed, they are in trouble partly because they insist on making hard choices, when what the economy really needs is to take the easy way out. The Great Depression happened largely because policy-makers imagined that austerity was the way to fight a recession; the not-so-great depression that has enveloped much of Asia has been worsened by the same instinct. Keynes had it right: Often, if not always, “it is ideas, not vested interests, that are dangerous for good or evil.”
It would be interesting to feed Krugman his decade-old words now, given that the Austrian-predicted “pushing on a string” problem has hit the United States and Europe as well as Japan. Japan tried to spend its way out of trouble and failed, just as Hoover and Roosevelt tried to spend the American economy out of trouble and failed. History definitively shows that Krugman is not telling the truth when he claims that government austerity was the cause of the Great Depression. No one claims that the Austrian theory of economics is flawless or holistically complete. But in objective scientific terms, as a predictive model, it is demonstrably far superior to Milton Friedman’s Monetarist model as well as the Neo-Keynesian model to which this hapless would-be critic subscribes.