Many rebuttals have been offered to Krugman’s attack on ABCT [=Austrian Business Cycle Theory]. I even wrote one myself. Krugman has admitted that Bob Murphy bested him. The purpose of this article is to show where all the holes are in Krugman’s Swiss cheese of an article.
I suggest you have a copy of Part One open, so you can see the context of what I’ll quote from there. Here goes:
1. Krugman asks: 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?
A mistake right off the bat. Krugman is interpreting the ABCT as saying a lack of demand in investment is what leads to a lack of demand in the economy as a whole. This is in keeping with his Keynesian understanding of the cause of recessions.
Keynes and Krugman assume there is only one possible cause of recessions, lack of aggregate demand. Krugman had this assumption so firmly in his mind that he thought Austrian Economics accepts it as well. That’s why his question makes sense to him. ABCT doesn’t explain why there is lack of aggregate demand, therefore it must be wrong.
Luckily, in his Great Leap Backward article, Krugman gets closer to understanding what ABCT is saying. In his own words:
So what is the essence of this Austrian story? Basically, it says that what we call an economic boom is actually…degradation of the country’s underlying productive capacity.
This represents a very radical step for Krugman, and he immediately tries to find new flaws in Austrian theory [which are beyond the scope of this humble article. See Bob Murphy’s reply]. According to Keynes, there is only one cause of a recession, lack of aggregate demand [=AD]. Austrians have an opposite view, that there are many causes for a recession, but lack of aggregate demand is not one of them. So for Krugman to step up and recognize that there might be another cause of recessions besides lack of AD, mainly degradation of the country’s productive capacity, is a huge departure from classical Keynes.
And this recognition of other causes for a recession exposes the first flaw in Krugman’s hangover article, right from the horse’s mouth.
2. Another flaw is in an implicit assumption we attributed to him in Part One, in order to make some sense of his thinking, to wit:
Say’s Law also states that if a person has an ability to demand, meaning money to spend, he will spend it.
Say personally may have believed this. But it is not part of Say’s Law, that products are paid for with other products. [For a discussion of this subtlety, you can look here, especially the paragraph that begins “Conceding that sometimes the savings might be hoarded, Say was for once less than satisfactory.”]
3. A third flaw is also of the same nature, an implicit assumption we laid bare in Part One, without which his argument makes no sense. He had asked:
…why doesn’t the investment boom—which presumably requires a transfer of workers in the opposite direction [= from consumption goods to investment goods] —also generate mass unemployment?
We explained that such a question assumes, among other things, that…
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.
And of course, that is a big mistake. A nominal increase in investment can come from newly created money or credit, which does not draw existing money away from consumption goods. In addition, the degradation of the country’s productive capacity has just begun in the boom stage. So that no one is actually fired from his job at McDonald’s yet. People leave McDonald’s to work in factories because they want to, not because they have to.
Contrast this with the bust, when people have to quit their jobs, because they have ceased to exist, due to, as Krugman puts it, degradation of the country’s underlying productive capacity.
4. David Gordon pointed out another flaw. I’ll quote him:
Our author [=Krugman] introduces a false issue by bringing in unemployment. It is not at all part of the Mises-Hayek view that liquidating malinvestments caused by overexpansion of bank credit requires mass unemployment. Quite the contrary, unemployment, as Austrians see matters, stems mainly from rigid wage rates. If workers accept a fall in wages, liquidation of the boom is compatible with full employment.
5. Krugman’s own explanation of recessions, that “a recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time.” is mistaken. We have written many articles in this humble blog to explain why. Do a search for “Keynes”.
6. Krugman writes:
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?
We have written may articles about the dangers and evils of “simply increasing the money supply”. You can do a search for “inflation” and for “monetary disequilibrium” and for “money shortage” to see them. In particular, I like The Myth of Money Shortage.
7. He also writes:
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.
Krugman himself has refuted this one in his Great Leap Backward article linked to above. It’s not just a few bad investments and bad loans here and there. The problem is much more serious. We are talking about, as Krugman himself puts it in his leap article, a degradation of the country’s underlying productive capacity.
8. Finally, he writes:
Why should this require that perfectly good productive capacity be left idle?
Again, he has already answered this one himself in his Great Leap article. The country’s productive capacity is not “perfectly good” at all. The boom created all kinds of wrong, twisted uses of our productive capacity. Cars that self combust. Huge supplies of SUVs nobody wants. Houses that lie empty and rotting. As Krugman put it, we have created a degradation of the country’s underlying productive capacity. And rather than printing money to keep that degradation intact, we should instead be doing all we can to fix our productive capacity.
9. As a little dessert, here’s a link to Bob Wenzel’s article, which exposes the not so subtle literary devices Krugman uses to poison the discussion in his hangover article.