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"Neanderthal" Economics

November 25, 2008

Tags Booms and BustsThe FedInterventionism

It seems the Austrian economist possesses more truth in his pinky finger than Paul Krugman in his entire Nobel Prize–winning body. What other explanation can there be for Krugman's consistent policy "solutions" to the current economic crisis, which would actually exacerbate the problem and lead to a deepening and prolonging of a recession? Austrians not only predicted the current financial crisis but can accurately diagnose it and prescribe the proper antidote. Krugman's recent New York Times article, "Depression Economics Returns," continues to demonstrate his ignorance of economic truth by presenting even more antidepression policies as solutions. In this article, we will analyze Krugman's recommendations and provide the Austrian cure, including what government can do to cure the recession.

Krugman begins with what he terms "depression economics," which is

a state of affairs like that of the 1930s in which the usual tools of economic policy—above all, the Federal Reserve's ability to pump up the economy by cutting interest rates—have lost all traction. When depression economics prevails, the usual rules of economic policy no longer apply: virtue becomes vice, caution is risky and prudence is folly.

Krugman's entire article rests on the (false) premise that the Federal Reserve's slashing of interest rates solves depressions. Of course, argues Krugman, we are now in Bizarro World—depression-economics world—where we call evil good and good evil, and where even the previous Federal Reserve "cure" will not work. Even on his own terms, Krugman is showing the relativism of his economic views: previous cures, in his opinion, are still susceptible to change.

In Krugman's seemingly relativist viewpoint, he states that economic policies no longer apply. Of course, contra Krugman, economic truths do not change; they are timeless and universal. Ah, but Krugman is not speaking of economics qua economist. When talking about "economic policy," Krugman has quickly and deceptively moved from the role of positive economist to normative ethicist. As Murray Rothbard stated in America's Great Depression,

Advocacy of any governmental policy must rest, in the final analysis, on a system of ethical principles … Those who wish to prolong a depression, for whatever reason, will, of course, enthusiastically support … government interventions, as will those whose prime aim is the accretion of power in the hands of the state.

Krugman correctly points out there is really nothing left to cut in the federal funds rate, and, he incorrectly asserts, "there's nothing to stop the economy's downward momentum." He believes there will be a contractionary spiral of higher unemployment, a lack of consumer spending and, therefore, lower business investments, which then lead to more job cuts. He assumes a static view, apparently with no fall in prices. None of these assertions is supported with any economic analysis, but what can we expect from a combination of a Nobel Prize winner in Wonderland and the New York Times, "where outright partisanship is substituted for economic analysis"?

But, alas, there is still hope. The solution, according to Krugman, is for government

to provide economic stimulus in the form of higher spending and greater aid to those in distress—and the [$700 billion economic] stimulus plan won't come soon enough or be strong enough unless politicians and economic officials are able to transcend several conventional prejudices.

Government "stimulation" will only further distort the savings-investment-consumption ratio. Government spending increases consumption and discourages savings and investment. Whereas, with private funds, some may be used to consume and some may be saved and invested, government funds are entirely consumed. Therefore, Krugman has the perfectly wrong idea of government spending and relief payments as a solution, which will only increase the depth and length of the recession. What is needed is less consumption and more saving, which will lead to a quicker recovery.

Krugman hopes Obama will, instead of giving in to "conventional notions of prudence," be daring enough to live up to Krugman's back-of-the-envelope calculations of an additional $600 billion stimulus. Again, in this paradoxical world called "depression economics," Krugman says we should not worry about budget deficits until the "crisis is past." If the budget were to be balanced, this could prevent Krugman's New Deal II from coming to pass. It is for this reason, he says, that we should throw caution out the window. In these conditions, "it's much better to err on the side of doing too much than on the side of doing too little." And, he claims, inflation can always be cured by the Federal Reserve raising the interest rate.

Since Krugman has given a dose of further poison to the already diseased economy, perhaps, by following the exact opposite of Krugman's recommendations, we can arrive at a true "Austrian" cure which will lead to a quicker recovery of the economy. By doing so, we will use a derogatory label given by conventional, Krugmanesque economists to the Austrian School: "Neanderthal economics."

When reading Murray Rothbard, you would think he is writing about current financial events. His books and articles are as important, fresh, and relevant today as when they were written, and most likely they still will be in 100 years. In one of his most important books, America's Great Depression, Murray lists six ways government could delay market adjustment, which he says would create the "favorite 'anti-depression' arsenal of government policy." These include the following:

  1. Prevent or delay liquidation
  2. Inflate further
  3. Keep wage rates up
  4. Keep prices up
  5. Stimulate consumption and discourage saving
  6. Subsidize unemployment

Unfortunately, government is actively pursuing all of these measures. For example, in terms of delaying liquidation, the US Treasury, under authority of the new "Emergency Economic Stabilization Act," purchased $40 billion in senior preferred stock in AIG—a company with losses of almost $25 billion in one quarter!—in addition to its low-interest loan of $60 billion from the Federal Reserve. Loans to other shaky businesses appear likely. Barney Frank, chairman of the House Financial Services Committee, is meeting with CEOs of GM, Ford, and Chrysler next week to discuss legislation to extend $25 billion to provide "liquidity" to the companies.

The Federal Reserve has lowered rates so that the effective federal funds rate is near 0% (see chart below), with the hope of encouraging lending and the extension of credit. A policy of easy money and credit will lead to more malinvestment, and possibly hyperinflation, a destruction of the currency. The market's return to higher interest rates and a credit contraction is necessary to cure the recession.

Concerning wage rates, there is little doubt that Obama as president will not allow wage rates to fall; in fact he aims to raise the minimum wage to $9.50 by 2011, and index it to inflation thereafter. All of Krugman's suggestions are aimed at stimulating consumption and discouraging savings. Many other government policies and interventions are sure to follow.

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However, there is something government can do in the Austrian cure for a recession: radically remove itself from the economy. It can cut spending and taxes, which will encourage saving and investment. It can allow businesses and banks to fail. It could abolish the central bank. It can allow prices to fall. A removal of regulations that hamper the free market will also aid the market in recovery. As Murray Rothbard wrote,

"In sum, the proper governmental policy in a depression is strict laissez-faire, including stringent budget slashing, and coupled perhaps with positive encouragement for credit contraction. For decades such a program has been labelled 'ignorant,' 'reactionary,' or 'Neanderthal' by conventional economists. On the contrary, it is the policy clearly dictated by economic science to those who wish to end the depression as quickly and as cleanly as possible."

Krugman, assuming he really wants to cure the recession, would be wise to leave Bizarro World, and to follow Neanderthal economics.

Chris Brown is a lecturer at the Australian Graduate School of Entrepreneurship. Comment on the blog.

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