Sunday, October 19, 2008

Krugman Doesn't Get It

After his recent win of a "Nobel" Prize in Economics (really the Bank of Sweden Prize), Paul Krugman has been lauded a bit by various (mostly liberal) pundits, and the supposed benefits of Keynesianism have been mentioned on several blogs, with the general import that Krugman and Keynes could solve our current woes. (Because Friedmanite economics was a large component of how we got into the mess, and Keynesian and Friedmanism are supposedly the only two schools out there).

Sigh, sigh, sigh.

To show that this is wrong, let's look at a discussion of the merits of Keynesianism vs. Austrianism. On the LewRockwell Blog, there was a discussion of an article that Krugman wrote back in 1998, attacking the Austrian School. First there was a link to the original Krugman article, and following it were links to refuting articles published by people from the Mises Institute (the links were added to the original linking post).

The refuting article are here, here, and here.

While the refutations are okay, I don't think that any of them provide a good, easy-to-understand point-by-point refutation of Krugman's statements (although some of them refute a few of his points, and they all seem to explain Austrian Theory, they do not provide a comprehensive explanation of how his entire view of the Austrian Theory of the business cycle is wrong). So here is my attempt to explain where Krugman's article went wrong.

Firstly, when discussing the "hangover theory," he acts as if this theory is separable from one's general theory of economics, and that one can critique the "hangover theory" in general without using one's overall economic theory as a context.

In any case, he goes on to say:

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,

Here is the first mistake he makes (David Gordon also noted this). He assumes that the reason for the investment boom getting out of hand is irrelevant. Actually, it is very relevant, because any "hangover theory" needs to explain how so many sectors of the economy go bad at once. Without a specific reason (and one with more explanatory power than "irrational exuberance" which essentially is throwing one's hands up), one can describe but not explain the phenomenon.

The reason for the boom-bust cycle, according to the Austrian Theory, is credit that is not supported by savings. This causes people to assume that there are more resources than actually exist, and to attempt to invest in projects which require more resources than are available to complete.

...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.

Uh - no. Not according to the Austrian Theory, at least. In fact, this sounds suspiciously like the Keynesian "acceleration principle," a subset of "underconsumption" theory. According to this theory, production of some durable good or service rises due to a sudden increase in demand, and then falls as that demand is satisfied. For example, there is a sudden demand for a 50% increase in compact fluorescent lightbulbs (CFLs). Then, because all of the extra bulbs will not burn out for 5 years, demand suddenly drops back to where it was before the increase, resulting in a glut of CFLs, and pushing the CFL-producing company to the edge of bankrupcy. (This is a flawed theory, largely because it assumes that the CFL makers (for example) cannot adapt their production and prices to anticipate future needs).

In any case, the flaw in this statement is the concept of "too much capacity," which is a fancy way of saying that too many goods were produced to meet the demand. While this can happen in certain industries, it seems unlikely to hapen in several economic sectors at once, and moreover, if there is actual overall "overproduction," demand will almost certainly grow to meet it.

The real problem, in any case, is not the overproduction of goods in general. It actually consists of one or both of two things:

(1) More projects started than can be completed using the resources currently available.

(2) Overproduction of one good or service, financed by underproducing another good or service, particularly if the underproduced good or service is complementary to the first.

Either of these things can (and is) often be referred to as "overinvestment," but are better referred to as "malinvestment." This is because the problem is not so much that too many resources were invested as it is that too many of the resources were invested at certain stages or certain parts of the venture, to the detriment of other stages or parts. In other words, it's not that too much was invested, but that the investment was unbalanced. We will refer to the cases above as the first and second types of malinvestment.

Let us take the two cases Krugman gives us, factories that cannot find markets and offices that cannot find tenants, and explain what Krugman thinks the problem is and what it really is.

In the case of the factory, Krugman seems to be indicating that the factory is producing more goods than consumers can consume, presumably due to a lack of purchasing power (too little money).

According to the Austrian Theory, the problem is not a factory without customers, but a factory that is unable to be completed or to scrounge up the resources to produce the goods it is designed for. Under the first type of malinvestment, the problem could be that the factory was made too big, bigger than the amount of resources that would be available to create it. So halfway through the construction, the price of labor and materials to complete the factory soars. Alternately, if the price is fixed by government fiat or by a previous agreement with the supplier, the supplier may find that he cannot produce enough to meet the demand and there is a shortage. Under the second type of malinvestment, the problem might be that the building of the factory depleted resources that were needed for the factory to perform its function. Because such a big factory was made, twice as many construction workers wre hired than would have been hired with a smaller factory. Because of this, the people producing the raw materials that the factory was going to buy cannot build their mines/refineries/wells/synthesis plants, etc, or cannot build them big enough to provide the big factory with the raw materials it needs.

In the case of the ofice building, Krugman posits that it cannot find tenants (again, presumably because they do not have the money to pay for the offices).

According to the Austrian Theory, the first type of malinvestment would be that the person who would own the building decides to put up two builidings instead of one, due to the cheap credit available. The problem again could be that there are not enough resources, and when he is halfway through, the price to complete the building soars, or material shortages postpone its completion. The second type of malinvestment might be that the buildings are both completed, but because there were not enough people looking for energy resources or building refineries/wells/mines/processing facilities, there is an oil/coal/uranium shortage and it becomes cost-prohibitive to heat both buildings in the winter to the extent necessary for working in the building to become feasible (or maybe it is cost-prohibitive to light the buildings and to provide the energy for computer use).

Since construction projects take time to complete, however, the boom can proceed for a while before its unsoundness becomes apparent.

Krugman is implying that the boom is driven by the consumption inherent in completing a business project, and that the bust occurs when the project is finished and consumption ends. Actually, the boom occurs at all because there are savings in the economy, and that as long as there are savings, the boom can last by people eating their savings. There are enough resources to complete some part of all of the projects. It's just that at some point before the projects are completed, there will not be enough savings left to complete all of them.

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.

Actually, what happens is that the market (by which I mean the collective results of various individual transactions) has to prioritize which projects will get the limited resources available so that they can be completed, and which ones have to end in order to free those resources up. The slump is necessary because the projects which are not prioritized will fail. Trying to save all of the projects will result in even fewer resources exisiting, with the result that while more projects will get closer to completion, more will eventually have to give up. Earlie liquidation is preferable, because it is better for 50% of the projects to fail 50% of the way to completion than for 75% of the projects to fail 75% of the way to completion.

And the issue is not simply failed new investments. If resources are frittered away on unsuccessful project, that also reduces the supply of resources needed to maintain existing production facilities. Perhaps an oil shortage makes it more expensive for a 50-year-old plastics company to keep producing plastics at the rate it did a year ago. Perhaps expensive electricity puts a baker out of business.

In any case, Paul Krugman writes:

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.

The question is not silly so much as nonsensical. The problem is not "investment demand." It is "investment supply," the pool of goods available to finance investment. The problem is not that "demand for investment" has dropped, it is that there are not enough resources to make the investments necessary to increase production, or even to maintain production.

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?

The fatal flaw in Krugman's story here is the assumption that total spending must remain constant. So if less is spent on investment, that surplus spending must go to consumption. The problem is that at the end of the boom there are simply fewer resources overall - if overall spending goes down, then less can be spent on both consumption and investment. If you define spending in terms of money rather than resources (e.g. actual dollars as opposed to "inflation-adjusted dollars,") then, as David Gordon points out, it is possible to have an increase in spending on consumption at the end of the boom, but that increase indicates higher prices rather than greater consumption. Alternately, there can be a decrease in dollar spending as well as in resource spending, in which case there is a "money contraction," i.e. credit-created dollars are simply destroyed.

It appears here that Krugman is not aware of the realtionship between investment and production, and therefore between investment and consumption. In the real world, investment in capital goods (e.g. factories and other productive technologies) allows for the production of consumer goods, which then allow for consumption. In Krugman's world, the consumption of goods drives their production, and investment is some totally unrelated phenomenon. Now, on a micro-scale it is certainly true that consumption drives production in the sense that when consumption of a good increases, people will tend to try to redeploy resources to produce more of that good. But this means producing less of something else; for overall production in an economy to increase, more must be invested in creating the means of production.

So Krugman finally gives us his explanation:

A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time.

There are at least two problems here. For one thing, Krugman doesn't give us any explanation as to why everyone's preferences change at the same time and in the same direction, instead using the hand-waving phrase "for whatever reason." Secondly, he sems to misunderstand what "cash reserves" are all about, as if it involves cash just sitting around idle.

Many Keynesians (and Friedmanites seem to look at savings and investment as two separate entities, when in reality they are two sides of the same coin. Savings goes into investment; when you put money in the bank, it doesn't stay there, the bank invests it by loaning it out. And personal investments, such as the stock market, are financed by money that you have not consumed somewhere else. Increasing one's cash reserves involves putting more money in the bank which then has more money to lend. Certainly if more people who have mortgages now were to start paying off more of the principle, it would give banks more cash on hand to use to fund credit in markets where it is drying up.

The point is, if people want to hold more cash, the economy will adjust to that.

In any case, misdiagnosing the problem, Krugman has a ridiculous solution:

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?

But if the problem is, as we Austrians argue, that there are too-many partially finished projects and not enough resources to complete all of them, won't this just encourage people to keep on trucking, using more of the depleted resources to continue funding projects that are doomed to failure?

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?

Krugman makes several mistakes here:

(1) He assumes that we can distinguish good and bad investments and loans easily (indeed that the problem is always that individual investments are bad). This also in an incomplete picture of what goes on in a recession. "Bad loans" are often bad only in context. It is not just that there are obvious good and bad projects, but that sometimes there are too many projects for all of them to be completed. It is not always easy to tell which investments should survive and which should not, and if the problem is merely a lack of resources to complete all of the investments then sometimes the choice will be arbitrary.

(2) He assumes that we can simply "junk" the bad investments and loans at will, and that expanding the money supply will in no way hamper us from doing so. In reality, an increase in credit will allow "bad investments" to be financed for longer, eating up more resources that could have been used productively. A credit crunch is how bad investments get junked, unless he wants some government manager to announce by edict who will no longer receive loans.

(3) He assumes that we have idle productive capacity, in the sense that there are factories with all the ingredients to make product that are idle for no reason. In reality, much of the productive capacity has been squandered, and we do not have the resources to produce until the economy has re-equilibrated, bad investments have been liquidated, and resources have been diverted to more productive uses.

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.

The reason is that the distorted economy does not have a place for everyone until the distortions are corrected. If there is a construction boom, followed by a bust when it is revealed that there are not enough resources to finsih all the buildings or to make all of them livable, huge numbers of construction workers will become unemployed because there is no need for more construction at this time. Perhaps some of them, freed from (currently) unproductive construction, will go into fields that need more workers, such as mining, lumbering, or the production of synthetic materials. Unfortunately, it may take time to get these increase the productive capacity of these industries enough to absorb the unemployed construction workers. Of course, eventually, if the productive capacity of these insdustries increases enough, a large number of the construction workers can go back to construction, as the resources now exist to make such a job productive.

Why must there be unemployment at all? Why cannot everyone just change to a more productive job?

Several reasons:

(1) Certain jobs require that certain capacities be online before they can be had. Most well-paying jobs require infrastructure. That infrastructure may not exist, and the economy take time to produce it. In the meantime, displaced workers may need to either be unemployed or to take menial jobs to hold them over, with a reduction in pay.

(2) Workers have certain specialties which are not always easily translatable. If there is a huge excess of computer hardware designers, yet the current economy needs more miners to extract the rare-earth metals to build computers, it is not likely that the designers wil be able to simply transfer to mining.

(3) It takes time for the market to determine which investments are bad and to transfer resources over the good ones, or for the market to determine which of the many potentially good investments is most worth saving when not all of them can be funded.

In any case, unemployment due to malinvestment need only take a short time, if the economy is allowed to correct itself and if liquidation is allowed to proceed, because more productive uses are found for workers who are displaced by the end of the boom.

Which brings us to the fourth reason why not everyone can simply transfer to a better job:

(4) The government is manipulating the credit market to keep all of the malinvestments solvent, and thus reducing the amount of resources available for productive investment. This keeps workers working at jobs that are not productive, and that increasingly squander valuable resources. It also prevents those who are displaced from finding productive work because the squandered resources are not available to build the infrastructure that they need to do the work.

Krugman (earlier in the piece) dismisses this idea as:

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.

Actually, it is a frictional problem created as the economy gets rid of unproductive jobs but has not yet created the more productive jobs that will replace them. The creation of productive jobs can be seen as a "booting" problem, much like computers need time to boot up after a restart. Unforunately, if the government intervenes to save the unproductive jobs, it makes it harder to use resources to create the more productive jobs, and make the period of adjustment longer.

The rest of the piece is about using Asia as a historical example. I don't know enough about the specific history, so I won't go into it right now.

So, what are we to make of Krugman's statement that recessions can and should be avoided by prolonging the boom?

What would happen if we did that?

What would happen would be fairly simple. If we discourage savings and encourage people to keep investing more in a time of great malinvestment, we will get more and more of our diminishing pool of resources going to unproductive uses. This will make the coming recession worse and worse. But what if we just keep pumping in money to keep the bubble going? Can't we simply put off the recession indefinitely?

No, because at a certain point all of our saved resources are gone. At this point, we are faced with two possibilities. Stop pumping in money and get a deflationary recession (credit contraction). Alternately, we could try to keep the boom going with more money creation, but without additional saved resources to buy with the money, all we will accomplish is for prices to skyrocket. This is known as hyperinflation, and the economy will contract whether the supply of money and credit contracts or not.

So in short, Krugman is all wet, and his Keynesian Theory ought to be taken about as seriously as the "phlogiston theory of fire," as he says of the Austrian Theory.

That is all.

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