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Older Paul Krugman attack on Austrian economics

April 20, 2005

Yesterday's daily article by William Andersson on Paul Krugman's recent dismissal of Austrian economics as religion was quite interesting. It might seem appropriate to remind everyone of a older attack by Krugman on Austrian economics, or more specifically, the Austrian business cycle theory (ABCT). He starts the article by telling of how someone attacked him for not paying attention to ABCT, something which he explains by saying ABCT is "about as worthy of serious study as the phlogiston theory of fire".

He then goes on to reformulate ABCT as a "hangover theory" which he blames for the Great Depression, because supposedly Herbert Hoover pursued a misesian policy, something which anyone who has read Rothbard's America's Great Depression knows is a ridiculous assertion.

He then sums up the hangover theory as follows: "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."

He then says that apart from the last part about the virtues of recession this is actually a good description of business 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 then he argues that there is no reason to assume that a investment cycle should result in a recession since a downturn in investment should be counteracted by a consumption boom. He dismisses the Austrian explanation that this won't happen because the shift away from investment to consumption means that the to some extent —at least in the short term— specific factors of production (both the workers and the capital goods)that previously produced investment goods will now become unemployed, thus reducing production by arguing that in that case the shift from consumption to investment should produce a bust too, rather than a boom. Actually, that is quite easy to answer.

The difference between the shift from consumption to investment and the shift from investment to consumption is that the former will mean that the amount of useable factors of production will increase (investment goods production is the production of the factor of production known as investment goods), while in the latter case the amount of useable factors of production will shrink, both as a result of reduced investment goods production and the fact that the already existing factors of production will to some extent be unemployed.

The argument that then follows from Krugman that it is not just the investment sector that contracts in a recession but all other sectors as well and that the investment cycle therefore cannot explain recessions is equally invalid. The relative spending on consumption always increase during recession, but it is just that because of the reduced purchasing power resulting from the contraction in the investment goods industries, absolute consumption spending might fall anyway. His last two paragraphs contains the myth that Japan following the bursting of their stock, and real estate bubble in the early 1990s pursued a misesian policy. Which is certainly not true, as Japan has increased the deficit to a higher level relative to GDP then even Bush has managed to achieve and as the Bank of Japan has cut interest rates to zero and tried hard to expand the money supply, although admittedly these attempts have been to a large extent unsuccessful because the sharp increase in the monetary base have been counteracted by declining bank lending.

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