Krugman's "The Hangover Theory"
Here' I am going to go through it line by line, explaining what is wrong with his rantings;
He starts out:
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.If he doesn't think it worthy of study, how does he know what enough about it to make such a judgment? Did he not study it?
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."
Austrians don't call it overinvestment. They call it MALinvestment.
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.It is important to note that recessions are not the punishment for ALL booms, or all good times. Healthy growth can take place without a subsequent bust. The important question is: "What caused the boom?"
The hangover theory is perversely seductive—not because it offers an easy way out, but because it doesn't.What do you mean, it doesn't? Austrian economists have their prescriptions for a return to growth and full employment. The problem may be that it gives nothing for government officials to do except get out of the way. But to someone who thinks that government is the solution to every problem, this may be understandable. To such a person, if government isn't doing anything, nobody is.
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.And if that is true, then so what? Now the problem I see here is that Krugman is ascribing a motive to adherents of an idea as a substitute for arguing about the theory itself.
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.OK, sure, Krugman ascribes to a different theory, and so has the right to explain what he thinks the consequences are of not folling HIS theory. I could criticize the idea of spending wealth that has not yet been created, but that's not my purpose here.
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.This is itself a nice thoery, except the fact is, though Hayek did argue against expanding credit and the money supply, THEY HAD NO INFLUENCE on the policy. Hoover and the Fed did the exact opposite of what Hayek would have and did argue for. The Fed tried to re-inflate, to provide a lot of new liquidity to prop up failing banks. Hoover tried to stimulate the economy through stimulus spending, in particular on public works projects. Hayek, von Mises, and other Austrian economists were arguing AGAINST the policies that were actually being implemented. See Murray Rothbard's "America's Great Depression" and Ludwig vomMises' Causes of the Economic Crisis.
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.A very simplistic description of the theory, but not too distorted. He leaves out a lot of things like time preference, malinvestment, and the capital structure of production.
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.Not really. There is never too much capacity for the production of wealth. There is never any set limit to the amount of wealth that human beings can consume, no shortages of new uses for anything that is produced. The problems arise when there is too much of some things relative to something else. People demand more textile goods, when the economy has been producing too much in the way of housing, or something similar. And since all prices in the economy, including wages, have been inflated, when a monetary shock sets in, there may not be enough money to buy all the goods and pay all the workers at the previous price level. So prices need to fall. More on this later.
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.Here, he gets something right. Reality strikes. The previous economic conditions were unsound, a fantasy created by throwing money at the economy. Money is a measurement of value, not its cause. Trying to make things happen by adding more money is just the equivalent to cracking open the dial on a pressure guage and moving the needle, instead of doing something to change the actual pressure being measured. The result is fantasy. But reality does re-assert itself.
The result is a slump whose depth is in proportion to the previous excesses.I'm not sure the depth of the slump is in proportion to the excesses. I doubt that an Austrian economist would say there is such a proportionality.
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.Partly right, but the fall in prices is actually PART of the healing process. In classical and Austrian economics, falling prices are a GOOD thing. Only in mercantilist and Keynesian economics can falling prices be considered bad. See George Selgin's "Less Than Zero".
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?Here, again, Krugman oversimplifies. Its not the ups and downs in investment that drive the business cycle. Its malinvestment. The economy has produced things that consumers don't want, so the businesses producing those goods lose business. That's where the slump is.
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 the Austrian theory DOES explain them, as he would know if he were to actually crack open a book on the subject. He leaves out the explanation, because he apparently doesn't know the theory. Since consumers aren't buying what producers have to sell, (which is because the low interest rates instead of consumer demand motivated them to produce those goods) they now don't know where to invest. Also, there may have been monetary deflation which has reduced the amount of money available to invest.
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.He's explaining Keyesian theory here, so I will let this pass, except that he claims it makes Austrian theory obsolete. That assumes that Keynes was right.
Up till now, all my criticisms of Krugman's essay have been pretty minor. Here is his first real big whopper:
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?Again, proof that Krugman doesn't know the theory he is pretending to criticize. The error in his logic and math is that both consumer and investment spending can fall at the same time, if there is monetary deflation. And that is just the simplest explanation. People can reduce their spending overall because consumers can't find the goods they want, they may have chosen to save more, people can't find good investments, and so on. They can simply choose not to spend.
And here is where he really shows his ignorance of Austrian theory:
And if so why should there be a rise in unemployment?That's an easy one. Austrians have long had an answer to this question. If there is monetary deflation, there is less money to go around. Especially if wages are held artificially high, as as Hoover did (Read Lee Ohanian's "What, or Who, Started the Great Depression?"), there just isn't enough money to pay all these workers. Not only that, some sectors of the economy have overinvested relative to others. They have hired more workers at the expense of other sectors, and letting those workers go so they can be hired elsewhere, where they would be more productive, is part of the healing process.
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.No, and No. They didn't realize this was a problem for their story, because their story explains it very well, as I already explained. And why does he seem to think Hayek and Schumpeter are the only business cycle theorists? How about Ludwig vonMises and Murray Rothbard?
Here is Ludwig von Mises explaining unemployment in depressions and recessions, especially in ones where wage rates have been propped up by government or powerful labor unions. From The Austrian Theory of the Trade Cycle:
Another factor which is helping to prolong the present period of depression is the rigidity of wages. Wages increase in periods of expansion. In periods of contraction they ought to fall, not only in money terms, but in real terms as well. By successfully preventing the lowering ofwages during a period of depression, the policy of the trade unions makes unemployment a massive and persistent phenomenon. Moreover, this policy postpones the recovery indefinitel~ A normal situation cannot return until prices and wages adapt themselves to the quantity of money in circulation.And:
The government must never try to prop up wage rates or prices of producers' goods; doing so will prolong and delay indefinitely the completion of the depression-adjustment process; it will cause indefinite and prolonged depression and mass unemployment in the vital capital goods industries.
If previous statements by Krugman were whoppers, the following is off the chart:
(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.")Now exactly where does any Austrian economist claim that mass unemployment is part of the process of recovery? As a matter of fact, they offer their remedies as a way to PREVENT mass unemployment. See the above quote from Ludwig von Mises.
That's easy. The industries and sectors of the economy which overexpand during the boom period get workers by bidding them away from other sectors, which is a slower and less visible process.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?
As explained by Roger Garrison:
Actual market processes, however, involve adjustments in both capital and labor markets that translate capital-market misallocations into labor-market fluctuations. During the artificial boom, when workers are bid away from late stages of production into earlier stages, unemployment is low; when the boom ends, workers are simply released from failing businesses, and their absorption into new or surviving firms is time-consuming.
One business hiring workers away from another does not require the worker to be unemployed in the meantime. And the extra money flowing into the economy provides the means to hire new workers as quickly as they join the workforce. The rate of new jobs that need to be created is easy to maintain. But when there is monetary deflation, a lot of workers are suddenly dumped on the economy at once, and it takes time to find work for all of them.
And anyway, this story bears little resemblance to what actually happens in a recession, when every industry—not just the investment sector—normally contracts.At least this isn't a misrepresentation of Austrian economics. But the thing is that, even if all businesses, industries and sectors of the economy contract, they don't all contract to the same degree. The housing sector and the financial sector were both bit harder than most. But the computer industry did fine.
Apple Computers, for instance had very healthy revenue. There are some spikes and dips afterwards, but recovery from the dips was pretty fast.
Pretty much the same thing for Microsoft. A bit of a dip around 2009, but an easy recovery. Nothing compared to the housing collapse or the financial crisis.
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.
It may be true that this can happen. The question is, WHY do they decide to increase their cash reserves? Very often, its because they don;t find what they want to buy. Businesses have been busy producing goods they don't want. Or they have lost trust in banks and investments, often for good reason. Nothing here is incompatible with the Austrian 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?Because that was the cause of the original problem in the first place.
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?But that IS the Austrian economists' prescription. Liquidate the bad investments, and take all that productive capacity and put it to better use. The problem is that increasing the money supply makes those bad investments look like they can be saved, and they don't get liquidated, they continue to be used unproductively, and end up idle again since there is not enough consumer demand for them. And by consumer demand, I don't just mean money, but also the actual desire to consume them, relative to other things they want.
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.There is no need for such an explanation, because unemployment is not needed. What is needed is for the workers formerly employed by the bad investments to be sent to work for better, more productive and profitable investments. As i said, the mass unemployment is the result of trying to stop this process of recovery.
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.Very mature. Imagine a motive for people's belief, so you can attack that instead of making a sound argument against the belief, which so far Krugman has failed to do.
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.Another imagined motive.
And some people probably are attracted to Austrianism because they imagine that it devalues the intellectual pretensions of economics professors.Not the intellectual pretensions of ALL economics professors. Just yours. Remember, people who believe the Austrian theory hold Austrian economics professors in high regard.
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.And Krugman doesn't like to lecture people on their failings? Almost every article of his I have ever read is a lecture demeaning people who disagree with him, accusing them of all sorts of moral and intellectual failings.
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?Japan's current malaise is not blamed on the bubble. It is being blamed on the Keynesian stimulus that is being used to try to lift it out of the malaise. As per the Austrian theory, stimulus is actually keeping Japan's economy down. They keep stimulating, yet the economy doesn't seem to recover.
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?Yup. And do you have any reason to believe that isn't true?
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.And don't Austrians say you should cut taxes? That's not one of the hard choices Austrians recommend. Did they cut spending? Abolish their central bank? Eliminate monetary inflation? Stop printing money? Go back to a gold standard? Allow workers' wages to fall?
The Great Depression happened largely because policy-makers imagined that austerity was the way to fight a recession;I quote Herbert hoover, the guy Krugman seems to think imagined that Austerity was the solution, from his 1932 nomination acceptance speech:
Two courses were open to us. We might have done nothing. That would have been utter ruin. Instead, we met the situation with proposals to private business and to the Congress of the most gigantic program of economic defense and counterattack ever evolved in the history of the Republic. We put that program in action.
Our measures have repelled these attacks of fear and panic. We have maintained the financial integrity of the Government. We have cooperated to restore and stabilize the situation abroad. As a nation we have paid every dollar demanded of us. We have used the credit of the Government to aid and protect our institutions, both public and private. We have provided methods and assurances that none suffer from hunger or cold amongst our people. We have instituted measures to assist our farmers and our homeowners. We have created vast agencies for employment. Above all, we have maintained the sanctity of the principles upon which this Republic has grown great.And
It is in accord with these principles and these purposes that we have made provision for $1,500 millions of loans to self-supporting works so that we may increase employment in productive labor.
It was in accordance with these principles that we have strengthened the capital of the Federal land banks--that, on the one hand, confidence in their securities should not be impaired, and that on the other, the farmers indebted to them should not be unduly deprived of their homes. It was in accordance with these purposes that the Farm Board by emergency loan to farmers' cooperatives served to stem panics in agricultural prices and saved hundreds of thousands of farmers and their creditors from bankruptcy. It was in accord with these ideas that we have created agencies to prevent bankruptcy and failure in their cooperative organizations; that we are erecting new instrumentalities to give credit facilities for their livestock growers and their orderly marketing of their farm products.
Notice how that last one especially violates the Austrian recommendations for overcoming a recession? As Ludwig von Mises said, in "The Austrian Theory of the Trade Cycle" (link above):
The sooner the depression-readjustment is gotten over with, the better. This means, also, that the government must never try to prop up unsound business situations; it must never bail out or lend money to business firms in trouble. Doing this will simply prolong the agony and convert a sharp and quick depression phase into a lingering and chronic disease.
Hoover increased government spending and deficits:
What - or Who - Started the Great Depression?
The theory is based on President Hoover's industrial labor program, in conjunction with the growing power of unions. In November 1929, Hoover met with the leaders of the major industrial rms and presented his plan to deal with a possible recession. He told them that at a minimum, they should not cut wages, and preferably would raise wages.
Remember Ludwig von Mises saying "The government must never try to prop up wage rates or prices of producers' goods; doing so will prolong and delay indefinitely the completion of the depression-adjustment process; it will cause indefinite and prolonged depression and mass unemployment in the vital capital goods industries."? Hoover did exactly what the Austrians and their "Hangover Theory" say he shouldn't have.
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."Interesting that Krugman doesn't consider his own ideas, or those of Keynes himself, to be very dangerous, since the ones being implemented right now are closer to his own than to any "hangover theorist's".