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Krugman and Hangover Theory

Over at the forums at mises.org, Krugman’s description of Austrian Economics as Hangover Theory has been quoted yet again. So time to take another look at his argument. Kudos to JJ for compiling a list of articles rebutting it. Also, Bob Wenzel has an article pointing out the sophistries paragraph by paragraph. Smiling Dave is going to lay out what he thinks is the key flaw, in simple language as always.

Most of the article is merely prettified name calling, with this one paragraph being the only argument against the Austrian explanation of booms and busts:

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?

He knows the answer to this one, and indeed spells it out in the next paragraph:

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.

Not sure why it’s vague. At any rate, having set the poor Austrians up for the kill, he now deals what he thinks is the knockout punch, or rather punches. We are going to deal only with the first of them. The fingers can only type so much. Here’s what he says:

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?

To which I reply “Has this man ever held down a job?” If you look in the papers and see a Help Wanted ad, and you like the new job and take it, will you be unemployed? Of course not. You only quit your old job because you were going right to work in the new one.

But if you walk into your office and see a note on your desk saying “You’re Fired”, will you be unemployed for a while? Probably, until you find a new place.

“Ah”, Krugman may reply. “But the investment boom meant money was leaving the consumer sector of the economy to go to the investment sector. Which means there was less money for the consumer sector. Which means there should have been firings in the consumer sector. But there weren’t. It’s a boom. So there. Thou hast been refuted, sir.”

Yeah, it sounds pretty good, if you have no clue whatsoever. So where’s the flaw?
You know what’s coming, guys. A homely tale by Smiling Dave to bring out the point very clearly.

Time to put on the thinking cap.

Ah, the heck with it. No parables this time; we’ll go straight for the jugular.

Austrians say that a boom and bust cycle always begins by new money being pumped into the economy. How did the new money get there? Doesn’t matter. History shows a few ways it could happen.

It could be that a new continent is discovered, rich in gold and silver, and a few trillion dollars worth of new gold and silver coins are minted. This happened to Spain after Columbus discovered America.

It could be that convenient banking laws make a certain country a very popular place to store ones money. This happened to Holland right before Tulip Mania, when money started flowing into Dutch banks from all over Europe.

It could be that the money is paper, and the govt prints and prints more of it like madmen. This has happened countless times in many places.

It could be that banks are allowed to hand out checks at will, even though they have no money in the vaults to cover them. When people take those checks to the store and buy stuff with them, they are using a kind of money, newly created out of nowhere. This happens as a matter of course all over the world. 

It could be that digital money is recognized as legal tender, and all it takes is a press of a computer button to make a few trillion new dollars. This is where we are right now in the US.

But no matter how the new money got here, the principal is the same. When the investment sector gets some of that new money, no money has been taken away from the consumer sector. The consumer sector keeps what money it has, so it doesn’t have to fire anyone. The investment sector then uses its new money to lure away workers from the consumer sector with Help Wanted ads. That’s why there is a boom, with no one getting fired. People just move from one job right into the next one.

The bust happens when, for reasons Austrian Economics explains, the investment sector wastes the new money on losing propositions. AE explains why this is inevitable. Hey, we can’t cover everything in one blog post, right? In any case, when the investors realize they have blown the money and there is no profit to be made in what they are doing, the firings start.

So there’s your answer, oh Nobel Laureate. The boom has new money to burn, so no one gets fired. When the time comes for the bust, the money has been wasted. There is no more money. The firings must begin.


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