Mises Wire

Paul Krugman’s Austrian Obsession

Paul Krugman seems to have a very unhealthy obsession with Austrian economics and especially the school’s theory of the business cycle. More than two decades ago, he attacked it (wrongly calling it a “Hangover Theory” and trying to make a morality play out of it), claiming it had the credibility of the “phlogiston theory of fire.”

Not surprisingly, he got the theory wrong then but has decided to dig that hole of willful ignorance even deeper with a recent attack in the New York Times. Like most Krugman posts, it has more economic fallacies than one can debunk in a short article, so I will stay with one point: Krugman’s belief that inflation is a cure-all to recessions and that anyone who opposes it does so out of ignorance at best and malevolence at worst.

Over the years, Krugman has touted inflation as an economic remedy in the manner that some have pushed Ivermectin as a cure for covid-19, although I suspect that Ivermectin might be the better bet. (I am making an analogy, not a medical statement, so if you send me an angry email about Ivermectin, I will delete the message without reading it.) My larger point is that Krugman is trying to separate himself from the Austrians by promoting inflation, something the Austrians cannot and will not support—and for very good reason.

In typical fashion, Krugman focuses upon a misnaming of the Frankfurt school by Mark Levin of Fox News as “proof” that Austrian economics is false:

It’s questionable how many of these self-proclaimed “Austrians” actually knew what they were endorsing. In general, when right-wingers talk about intellectual history, you want to fire up your fact-checking. For example, Mark Levin of Fox News has a best-selling book claiming not just that the current American left is in the thrall of European Marxists but more specifically that they’re followers of Herbert Marcuse and the Frankfurt School—except that he keeps calling it the “Franklin School.”

The study of logic calls this a non sequitur in which he takes someone who would not be called an Austrian economist under any circumstances and then claims that Levin’s misnaming of the Frankfurt school proves Austrians are not to be taken seriously. (Perhaps this is New York Times logic.)

After opening with a logical fallacy, Krugman goes on to misrepresent the Austrian position on the causes of the Great Depression (and why it lasted through the 1930s) and make false claims about the Austrian version of the “debate” between Austrians and Keynesians:

And the idea that there was a titanic intellectual battle in the 1930s between Hayek and John Maynard Keynes is basically fan fiction; Hayek’s views on the Great Depression didn’t get much intellectual traction at the time, and his fame came later, with the publication of his 1944 political tract “The Road to Serfdom.”

Nonetheless, there was an identifiable Austrian analysis of the Depression, shared by Hayek and other economists, including Joseph Schumpeter. Where Keynes argued that the Depression was caused by a general shortfall in demand, Hayek and Schumpeter argued that we were looking at the inevitable difficulties of adjusting to the aftermath of a boom. In their view, excessive optimism had led to the allocation of too much labor and other resources to the production of investment goods, and a depression was just the economy’s way of getting those resources back where they belonged.

I am unaware of any Austrian economics literature that claims there was a “titanic battle” between John Maynard Keynes and F.A. Hayek. In fact, Austrians agree that while there was some interest in the Austrian business cycle theory in the early 1930s, it quickly was eclipsed, at first with the flurry of New Deal legislation in 1933 and later with the publication of Keynes’s General Theory. None of the best-known Austrian economists, from Ludwig von Mises to Murray Rothbard to any of the modern Austrians, ever has made the claim that Krugman attributes to them.

Then there is the actual Austrian analysis itself. Krugman misrepresented it in his “Hangover Theory” article, so we should not be surprised that he does it again. First, and most important, Austrians do not look at “excessive optimism” as a cause of anything, let alone an unsustainable boom. Instead, they look to the actions of monetary authorities that hold down interest rates at below-market levels, a practice that leads to malinvestment in long-term capital goods, investments that ultimately are not sustained by the direction of consumer spending and overall savings from individuals. In the short run, such policies lead to a boom that is supported in large part by borrowed money, and if there is “excessive optimism,” it comes from the results of misguided policies.

Krugman’s next statement demonstrates his misunderstanding of the Austrian theory and also his shortsightedness about what happens in a boom:

This view had logical problems: If transferring resources out of investment goods causes mass unemployment, why didn’t the same thing happen when resources were being transferred in and away from other industries? It was also clearly at odds with experience: During the Depression and, for that matter[,] after the 2008 crisis, there was excess capacity and unemployment in just about every industry—not slack in some and shortages in others.

Krugman simply is wrong here. In brief, while Austrians point out that the artificially lowered interest rates induce business owners to expand lines of production that ultimately will prove unsustainable, the point they make is that consumer spending patterns demonstrate that typical economic price signals are not showing that consumers now are abstaining from present consumption and increasing their savings. Instead, consumers continue to spend in the same spending/saving relationships as before, and while the structures of wage incentives are such that wages rise in the capital goods industries, those wages rise in order to entice workers to leave the consumer goods employment and migrate to capital goods. (Roger Garrison in Time and Money spells this point out in much more detail and much more lucidly than I can present it here.)

In other words, contra Krugman, the reason we don’t see patterns of unemployment is because there is no slack in consumer goods sales, so workers in those industries are not being laid off. Likewise, workers in capital goods are enjoying higher wages, but they are not saving their pay, or at least not saving it in proportion to what is needed in order to keep the investments in capital goods sustainable. Instead, like others in the economy, they are buying consumer goods.

This is not a trivial point, for much of Krugman’s argument hinges around his claim that since we don’t see patterns of mass employment in a boom, the Austrian theory cannot possibly explain mass employment during the bust. Furthermore, Krugman’s entire economic world view is based upon his belief that recessions are caused by decreases in “aggregate demand,” so booms are desirable because they are sparked by such demand. Once a bust occurs, he argues, government must increase its own spending in order to try to recover the boom conditions.

What Krugman fails to understand is that the conditions of a credit-induced boom are far different than a situation in which consumers begin to save more for the future, thus making funds available for long-term capital expansion. In the latter situation, factors would be bid away from the production and sale of consumption goods in an orderly manner, with wages in the capital goods industries being higher  (since there is increasing demand for such goods) than they are in the creation and sale of consumer goods, so the labor migration would not be a problem.

In a boom, however, there is no decreased demand for consumer goods and corresponding demand increase in capital goods industries. Instead, there is increased demand for capital goods and increased demand for consumption goods, something that would not occur if the boom were fed by savings instead of government-sponsored credit. It is clear that Krugman does not understand this point, and why should he, given that all of his economic writings on booms and downturns are based upon the assumption that factors of production are homogeneous instead of being heterogeneous, as they are in Austrian theory?

This important point carries into Krugman’s Keynesian prescription for reducing unemployment following a bust. He writes:

Hayek and (Joseph) Schumpeter were adamantly against any attempt to fight the Great Depression with monetary and fiscal stimulus. Hayek decried the use of “artificial stimulants,” insisting that we should instead “leave it to time to effect a permanent cure by the slow process of adapting the structure of production.” Schumpeter warned that “any revival which is merely due to artificial stimulus leaves part of the work of depressions undone.”

But these conclusions didn’t follow even if you accepted their incorrect analysis of what the Depression was all about. Why should the need to move workers out of a sector lead to unemployment? Why shouldn’t it simply lead to lower wages?

The answer in practice is downward nominal wage rigidity: Employers are really reluctant to cut wages, because of the effects on worker morale. Here’s the distribution of wage changes in 2009–10, from the linked paper:


Distribution of wage changes, 2009–10. Credit … Fallick et al[.]

The big spike at zero represents large numbers of employers who had an abundance of job applicants but didn’t want to cut wages, so they just left them unchanged.

However, if wages can’t fall in the sector that needs to shrink, why can’t they increase in the sector that needs to expand? Sure, it would lead to a temporary rise in inflation—but that would be OK. (emphasis mine)

Krugman believes (as did Keynes) that instead of encouraging wages to fall as labor demand decreases in a bust, governments should inflate the currency in order to reduce the real wage even as it is boosting the nominal wage. Keynes argued in The General Theory that using inflation to decrease real wages not only reduces the accompanying strife when workers see their wages cut, but also would not result in a loss of “aggregate demand,” thus being superior both economically and morally.

Both Krugman and Keynes also argue that permitting wages to fall would reduce “aggregate demand” and would lead to a downward spiral in production and unemployment, resulting in what Henry Hazlitt in The Failure of the New Economics described as a perverse equilibrium, all fed by a liquidity trap. (Hazlitt was explaining the Keynesian position, not endorsing that viewpoint.) Thus, Krugman’s endorsement of what he calls “transitory inflation” is based upon a belief that inflation is the only viable option to ending an economic downturn.

One might be able to make this argument if factors of production were homogeneous and it didn’t matter where one spent money—just as long as it was spent. However, if factors are heterogeneous, then Krugman’s Keynesian inflation strategy is extremely troubling, for it would result in economic dislocations that only would be made worse by subsequent rounds of inflation by monetary authorities.

This point is vitally important to understanding government economic intervention. In a price system, we value goods relative both to money and to each other. As the supply of money increases (or decreases), not only does the value of individual factors change relative to money, but the value of factors changes relative to other factors.

Krugman uses the example of what happened in the pandemic, thinking that the situation he describes discredits the Austrian school when, in fact, it undercuts Krugman’s analysis. Writes Krugman:

Although we aren’t hearing much about Austrian economics these days, the pandemic really did produce an Austrian-style reallocation shock, with demand for some things surging while demand for other things slumped. You can see this even at a macro level: There was a huge increase in purchases of durable goods even as services struggled. (Think people buying stationary bikes because they can’t go to the gym. Hey, I did.)

When authorities declared some industries “essential” while closing “nonessential” ones, they also changed the relative value of factors of production, and Krugman accurately describes this in the preceding paragraph. Yet, even with a real, live example before him that he acknowledges, Krugman then goes on to call for a policy “prescription” that is based upon the assumption that factors are homogeneous.

Krugman seems to be able to accept that relationships between factors can be changed when authorities openly favor some industries over others, but he cannot accept the fact that when governments intervene in markets both monetarily and fiscally the same kind of thing can happen. Instead, he quickly reverts to the thinking that if governments inflate, then inflation restores a low-unemployment equilibrium to the economy.

In his 1998 article in Slate, Krugman argues that the Austrian position on business cycles seems to be borne more out of a perverted sense of morality than anything economic. In his view, the Austrians are like the stern fictional schoolteacher Ichabod Crane, who sternly keeps his students in line. Instead of seeking the overall good of the economy, Austrians (according to Krugman) believe that a boom is a sort of bacchanalia that must be punished by a recession, thus blinding them to the need to continue a boom once people mysteriously stop spending money and grind the economy to a stop.

Yet an economy cannot have heterogeneous factors of production at one moment, then seemingly transform them into homogeneous factors when the government turns on the inflation spigots. That simply is not logical, and while Krugman regularly uses logical fallacies in order to belabor his points, one assumes that even he can see the error in his own conflicting analysis. But, then again, maybe not.

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