A Terrible Blogger is Born!

January 10, 2009

Krugmania! or, teaching Keynes, jr. some economic sense

Filed under: Contra Keynes,Economics — rmangum @ 1:33 am
Tags: , ,

Nobel Prize-winning Keynesian economist Paul Krugman’s recent editorial says “Congress must act fast to stave off deep depression”.  He argues that we are beginning to see a situation reminiscent of the Great Depression, that the Friedman-influenced monetary policy pursued by the Fed in recent years has failed, and that we need to return to the old Keynesian fiscal approach and engage in massive spending on (presumably, though Krugman is not specific) public works projects. His greatest fear is that Congress will drag their feet, and we will have what economists call “implementation problems” (you know, like Stalin had with the Kulaks).

Because we all know that Congress hates emergency situations which require them to pass sweeping legislation. You practically need to twist their arms.

Now, I don’t want to get into a big theoretical discussion here, not only because I’m not qualified, but because the situation doesn’t really require it. I’m more concerned with the logic of Krugman’s argument, and the rather dishonest way he presents it.


Dr. Keynes gives Lady Liberty her latest dose.

First of all, there is the way he restricts the debate, as if there are really only two schools of economic thought, following Keynes, which favors strong Government intervention in the economy, and Milton Friedman, which favors “the free market”. The reality is that Keynesianism and monetarism are really two sides of the same weltanschauung, the former a liberal and the latter a conservative approach to neoclassical economics. Keynesians like to focus on “fiscal policy”, that is to say the use of government spending authorized by Congress to stimulate the economy, whereas monetarists focus on monetary policy originating from the Federal Reserve, essentially to do the same thing via the banks. What the monetarists have always wanted was regular, institutionalized inflation, as opposed to the wild and unpredictable sort vested in the hands of politicians recommended by Keynes. I completely agree with Krugman that the recent economic disaster shows the monetarist approach to be faulty (actually, even this is not really all that accurate, since the Fed abandoned the Friedman approach of increasing the money supply at a fixed rate a long time ago), but this doesn’t follow that this necessitates a (rather orthodox) return to Keynes if there are other theories besides those two. It turns out that there are.

Is the Federal Reserve a free-market institution? No. It was established by legislative fiat. There is a free market school of economics, called the Austrian School, which places the blame for business cycles squarely at the feet of the Fed pursuing exactly the kind of policies Alan Greenspan pursued, driving the interest rate below its natural level and creating distortions leading to malinvestment. Krugman has actually dealt with this theory before. Well, not “dealt with”, because he does pretty much everything else besides dealing with it on an analytical level, from dismissing it as passe, saying he finds it “as unworthy of serious study as the phlogiston theory of fire” (why an article attacking it then?) to accusing it of being moralistic (and the appeal of public works projects aren’t as much emotional as economic?), to mischaracterizing the theory entirely, making some other elementary mistakes like referring to Josef Schumpeter as an Austrian Economist, who while an Austrian and an economist nevertheless had nothing to do with this particular theory.

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.

It is a straw-man which has some resembling features, but also some ridiculous errors. “Irrational exuberance”, for instance, has nothing to do with Austrian theory, though it is often part of the Keynesian explanation. The summary suffers from an overall analytical sloppiness. It leads one to believe that the problem is too much overall investment, when in fact the theory holds the problem to be the wrong kinds of investment due to signal distortion emanating from the Fed. And that’s another thing. What the hell good is a discussion of Austrian business cycle theory that never even mentions the Federal Reserve? You never find phrases like “maybe” and “for whatever reason” in the Austrian literature, which is not vague on where the problem originates.

Better and more detailed rebuttals to Krugman’s article on the Austrian theory have been made here and here. The theory has acutally never been refuted, unlike the Keynesian approach.

That’s right. Krugman is now arguing for an increase in government spending, But that’s only half the story of the Keynesian fiscal approach, which is supposed to pump money into the economy during a recession through spending and tax cuts (for the working classes, who save less than the rich)- not that this is Obama’s current approach, endorsed by Krugman- and suck it out when the economy is growing too fast (however you’re supposed to be able to tell that- in practice it just simply isn’t done at all) with higher taxes and less spending. The government pushes the gas or the brakes. (It’s always some mechanical metaphor, levers and hydraulics, someone there to drive the car, witness and adjust, control the horizontal, control the vertical, etc.) The problem here is that this paradigm works only as long as there is a tradeoff between recession and inflation. You cannot have both. But we did have just that, in the seventies “stagflation” that occurred after years of Keynesian management of the economy after World War two. Austrian economist Murray Rothbard loves to tell the story about how, in the 1950’s, he asked then-Fed Chairman Arthur Burns what would happen if there were indeed both rising unemployment and rising prices, who replied, “Then we would all have to resign.” This shows how central this model is to the Keynesian paradigm. Stagflation was probably the reason Friedman’s theories became so popular, which, far from being a return to laissz-faire that both liberal Keynesians and the Friedmanites like to paint it as, shifts the onus of economic control from from the congress or the executive to the supposedly independent Fed, from Clinton to Greenspan as it were. It’s clear that Krugman  needs to offer us something new, not assert that “Keynes had it right the first time.”

That something new may actually turn out to be something old.

Remember, this is the guy who just won the Nobel prize. But I never find his logic convincing. I recently heard an interview with him on NPR’s “Fresh Air” where he was stumping for increased spending to pull us out of recession. Terry Gross rather innocently asked him where the money would come from. He responded that the government ultimately can rely on the prosperous American economy as its tax base. Did you spot the circularity?

Keynesians always say the Austrians need to use more math. Perhaps they need a lesson in basic logical fallacies.

P.S.-For those not bored to tears with macroeconomic theory, I suggest  listening to two recent podcasts from EconTalk. The first is an interview with Pete Boettke on the Austrian view of business cycles. While not the most cogent explanation of ABCT (which is found here), he does come up with a very good metaphor of the Keynesian vs. Austrian views of capital structure, comparing the former to play-dough and the latter to Legos. The second features Steve Fazzari defending the Keynesian theory (and doing a better job of it than Krugman) of underconsumption and the paradox of thrift.


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