In that article, Krugman lays out his understanding of Austrian Theory of business Cycles, and his crushing [or so he thinks], rebuttals. Since we have a lot to say, we are going to write two parts. Part one [this article] will summarize Krugman’s position. Part Two will show the flaws in his thinking. Shall we begin?
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.
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.
So far, so good.
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?
For Krugman, the problem is “lack of investment demand.” In other words, too many houses were built, more than the demand called for. But that is not really a problem except in the housing market. There’s plenty of demand for everything else. So just because houses won’t sell, why does that shut down every other industry?
In another article, Krugman says this is the first of two key flaws in Austrian theory.
It doesn’t explain why recessions reduce [sic, should be “increase”] unemployment across the board, not just in industries that were bloated by a bubble.
In fact, Krugman is about to argue, unemployment in the bloated industry should mean even more employment everywhere else, certainly not less:
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?
Wait a minute. That’s a non sequitor. How does it follow that if total spending equals total income, [by definition] that what is not spent on investment goods must be spent on consumption goods? What is he even talking about?
I think what he is arguing is a hastily slapped together paraphrase of Keynes. Keynes argued as follows:
1. Say’s Law states that ability to demand comes from having produced something people want to buy. Thus, every article produced gives an ability to demand. So if we add up the dollar value of all that is produced, it adds up to the dollar value of ability to demand. [This is what Krugman meant with his “simple arithmetic”sentence].
2. Say’s Law also states that if a person has an ability to demand, meaning money to spend, he will spend it.
3. Thus, if the ability to demand is there for every product made, and every last penny of ability to demand will be used, why is less investment a problem at all, outside of the industry where less investment takes place? The money not spent on investment will be spent on something, by 2. “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?
In other words, for every worker laid off in the real estate market in Boston, there will be a Help Wanted sign in McDonald’s, since the money is now being spent on consumer goods. So why is there unemployment? The Austrian response is pretty lame, says Krugman:
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.
Which is maybe possible, admits Krugman, but leads to theoretical problems for the Austrians. In that other article, he writes that this is the second of the two key flaws in Austrian theory:
It doesn’t explain why there isn’t mass unemployment when bubbles are growing as well as shrinking…
And he says it here, too:
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?
In other words, there is no reason to really think spending money moving from one part of the economy to another will create mass unemployment and recession, according to Krugman. But if we grant for the sake of argument that it does, as Austrians think, then we can never have booms.
Here is his reasoning in syllogism form:
1. Austrians say booms are caused by increased spending in some investment market.
2. But the money for that increased spending had to come from somewhere.
3. Since there is always the same amount of money in an economy, an increase in spending in investment means a decrease in spending in consumer goods.
4. Austrians also say that a movement of spending money from part of the economy to another causes massive [frictional] unemployment.
5. Then by 3, a boom in housing, say, should cause massive unemployment somewhere else.
6. Thus there can never be a boom without massive unemployment somewhere, according to Austrians. But that is clearly false in the real world.
Having thus struck two supposedly decisive blows to Austrian economics’ explanation of recessions, Krugman comes through with his own explanation for recessions:
A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time.
In other words, forget about booms in investment. They don’t have to happen to cause a recession. All we need is for folks to hoard money. Remember the assumption Say’s Law makes, that if a person has an ability to demand, meaning money to spend, he will spend it? That assumption [which we labelled as 2 when summarizing the first flaw in Austrian economics] is just wrong. A person may have money to spend, but decide not to spend it. Lack of aggregate demand. Which brings on recessions. End of story.
This is Krugman’s solution to his first question. Why does a bust in investment not lead to a boom in consumer goods? Because Say is wrong. Unlike what Say thinks, money that is not spent on investment might not be spent on anything.
And of course, the second flaw of AE doesn’t apply to his theory either, because he doesn’t believe that massive frictional unemployment is caused by money moving from sector to sector. The massive unemployment is caused by money not going to any sector at all, but staying unspent in people’s wallets.
There now remains one last nail to hammer into the coffin, and we can bury AE forever, says Krugman:
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?
Not enough money? Print more! What could be simpler?
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.
In other words, those are side problems that have nothing to do with the essential matter, that we must print more money.
Why should this require that perfectly good productive capacity be left idle?
In other words, it’s not like everyone is making Chevy Volts that spontaneously combust. What’s unsold on the shelves is perfectly good stuff. Why waste it? Why fire people who are making it? Why not print more money so people can hoard as much as they want, plus have cash left over to buy everything on the shelves, plus buy whatever new stuff will be made because people are keeping their jobs? Why this Austrian insistence on doing nothing and letting what is already made rot away and having unemployed people stay unemployed for who knows how long?
There you have it. Those are Krugman’s arguments against Austrian Economics. Tune in next time for the rebuttals.