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Cycle Debate

December 2, 1998

Austrian business cycle theory has become the subject of a raucous debate. It began with an article by Austrian journalist Gene Epstein, writing in Barron's about the work of Keynesian Paul Krugman of MIT. Krugman blasted back in the pages of Slate with a hit on the Austrians that fails to fully understand the theory.

Excerpts follow:

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Gene Epstein from Barrons (Nov. 9, 1998):

A couple of weeks ago, when I visited Krugman in his office at MIT in Cambridge, Massachusetts, the economist was hunched over his word-processor, but paused to greet me cordially, then begged a few minutes to finish his work....

An undergraduate economics major at Yale, then an economics doctoral student at MIT, a former staff member with the Council of Economic Advisers under President Reagan and now the Ford International Professor of Economics at the institution that trained him, Krugman struck me at the end of the day as not quite any of these things. Rather, he seemed more the Long Island high school student he once was-the Smartest Kid in the Class, accustomed to getting attention for wit and insight.

I did have some conceptual bones to pick with him, and over the course of the afternoon he responded with good humor and even at times gave a little ground -- such as on his long-held opinion about the speed limits on economic growth. But on one point, he stone-walled.

I objected to his having written that, before John Maynard Keynes came along, the world's understanding of recessions was "in a state of arrested development." Wasn't he familiar with the Austrian theory of business cycles, as set forth by Ludwig von Mises, Friederich Hayek and their American disciple, Murray Rothbard? He allowed that he wasn't, implying that such ideas were off his radar screen, since they couldn't be expressed mathematically.

In fact, however, the Austrians wrote brilliantly about the supply-side, and what they had to say is quite relevant to an understanding of the global slow-down.

Take Krugman's creative Keynesian-style solution for curing Japan's ills. He proposes that the central bank flood the system with money, to induce inflation. Then, the rate of price rise will exceed the cost of credit, bringing the much-needed magic of negative real interest rates (a condition in evidence last week, when investors in Japan were paying prices for six-month Japanese treasury bills that ensured negative yields). And when the price of funds gets into minus territory, both business and consumer will be induced to borrow again.

That's a demand-side approach with a lot to say for itself, but it ignores supply-side problems. For example, High Frequency Economics chief economist and Japan-watcher Carl Weinberg says he welcomes Krugman's proposal, but speaking as a "practitioner" -- meaning that he sees things that academics don't -- he believes that certain steps must be taken before such concepts can take effect. First, he says, deal with the problems of the banking system and its gargantuan burden of non-performing loans, lest the monetary expansion be for naught.

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Paul Krugman writing in Slate (December 3, 1998):

A few weeks ago, a journalist devoted a substantial part of a profile
of yours truly to my failure to pay due attention to the "Austrian theory"
of the business cycle--a theory that I regard as being about as worthy of
serious study as the phlogiston theory of fire. Oh well. But the incident
set me thinking--not so much about that particular theory as about the
general worldview behind it. Call it the overinvestment theory of
recessions, or "liquidationism," or just call it the "hangover theory." It
is the idea that slumps are the price we pay for booms, that the suffering
the economy experiences during a recession is a necessary punishment for the
excesses of the previous expansion.

The hangover theory is perversely seductive--not because it offers an
easy way out, but because it doesn't. It turns the wiggles on our charts
into a morality play, a tale of hubris and downfall. And it offers adherents
the special pleasure of dispensing painful advice with a clear conscience,
secure in the belief that they are not heartless but merely practicing tough

Powerful as these seductions may be, they must be resisted--for the
hangover theory is disastrously wrongheaded. Recessions are not necessary
consequences of booms. They can and should be fought, not with austerity but
with liberality--with policies that encourage people to spend more, not
less. Nor is this merely an academic argument: The hangover theory can do
real harm. Liquidationist views played an important role in the spread of
the Great Depression--with Austrian theorists such as Friedrich von Hayek
and Joseph Schumpeter strenuously arguing, in the very depths of that
depression, against any attempt to restore "sham" prosperity by expanding
credit and the money supply. And these same views are doing their bit to
inhibit recovery in the world's depressed economies at this very moment.

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 factoriesthat 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. 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? Don't say that it's
obvious--although investment cycles clearly are associated with economywide
recessions and recoveries in practice, a theory is supposed to explain
observed correlations, not just assume them. And in fact the key to the
Keynesian revolution in economic thought--a revolution that made hangover
theory in general and Austrian theory in particular as obsolete as
epicycles--was John Maynard Keynes' realization that the crucial question
was not why investment demand sometimes declines, but why such declines
cause the whole economy to slump.

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?

Most modern hangover theorists probably don't even realize this is a
problem for their story. Nor did those supposedly deep Austrian theorists
answer the riddle. 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. (Hence their opposition to any
attempt to increase demand: This would leave "part of the work of depression
undone," since mass unemployment was part of the process of "adapting the
structure of production.") 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? And anyway, this story bears
little resemblance to what actually happens in a recession, when everyindustry--not just the investment sector--normally contracts.

As is so often the case in economics (or for that matter in any
intellectual endeavor), the explanation of how recessions can happen, though
arrived at only after an epic intellectual journey, turns out to be
extremely simple. A recession happens when, for whatever reason, a large
part of the private sector tries to increase its cash reserves at the same
time. 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? 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. Why should this require that
perfectly good productive capacity be left idle?

The hangover theory, then, turns out to be intellectually incoherent;
nobody has managed to explain why bad investments in the past require the
unemployment of good workers in the present. Yet the theory has powerful
emotional appeal. Usually that appeal is strongest for conservatives, who
can't stand the thought that positive action by governments (let
alone--horrors!--printing money) can ever be a good idea. Some libertarians
extol the Austrian theory, not because they have really thought that theory
through, but because they feel the need for some prestigious alternative to
the perceived statist implications of Keynesianism. And some people probably
are attracted to Austrianism because they imagine that it devalues the
intellectual pretensions of economics professors. But moderates and liberals
are not immune to the theory's seductive charms--especially when it gives
them a chance to lecture others on their failings.

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For Epstein's response, click here.

Also see Roger Garrison's compelling critique here.

For more on the Austrian theory, see the Austrian Theory of the Trade Cycle and Roger Garrison's article on New Classical Economics.

Also see Henry Hazlitt on the failure of Keynesianism.

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