My view is that the fatal flaw in Austrian economics is that it can’t explain unemployment — or, worse, that it thinks that it can explain unemployment, but is deluding itself. The Austrian view is that unemployment in a slump results from the difficulty of “adaptation of the structure of production” — workers are unemployed as resources are painfully transferred out of an overblown investment-goods sector back into production of consumption goods.Krugman has wrongly attacked Austrian Economics before, using this same argument and then calling the Austrian Theory of the Business Cycle a "hangover theory." However, as Robert Murphy has explained, the ATBC is not a theory that claims that good times automatically must lead to bad times; instead, it is a theory that concentrates upon malinvestments that occur during and boom and must be liquidated.
But this immediately raises the question, why isn’t there similar unemployment during the boom, as workers are transferred into investment goods production?
Unfortunately, Krugman's claim that Austrians cannot explain why there should not be high unemployment during a boom (because assets are being pulled in a direction away from what consumers would prefer through their purchases) actually contradicts his own Keynesianism. Remember, under Keynesian theory, all factors, including labor, pretty much are homogeneous, so labor automatically would transfer into the booming sectors, and Krugman's so-called refutation is built upon an assumption that labor is fixed and cannot move elsewhere. This makes no sense at all, but, then Keynesianism is a crude theory that does not stand up to scrutiny.
Krugman goes on with yet another straw man argument:
I’ve asked this question repeatedly over the years, and all I get is one of two things: gobbledygook, or “but during the phase of rising investment, the economy is booming!”, which is of course circular. In practice, Austrians seem to be Keynesians during booms without knowing it; they realize that high demand produces a boom, but don’t realize that this contradicts their own theory of slumps.Actually, Austrians have given clear answers, but Krugman does not want to hear them, resorting to insults instead. The article I listed earlier by Robert Murphy goes into rich detail in answering each of Krugman's points. Here he deals with Krugman and capital theory:
You can't understand Austrian business-cycle theory (ABCT) unless you first understand the Austrian view of the capital structure of the economy. In this article,I showed how Krugman was simply incapable of grasping ABCT because he lacks a rich enough model of capital. For those newcomers who are unfamiliar with ABCT, I strongly encourage you to read the fuller discussion in the hyperlinked article.Here is another Murphy quote regarding why there would not be unemployment in other sectors:
On the other hand, other sectors don't need to contract, because (unlike the scenario of genuine savings) nobody is cutting back on consumption. This is precisely why the Fed-induced boom is unsustainable — real resources have not been released from consumer sectors in order to fuel the expansion of the capital sectors. Because modern economies are so complex, the charade can continue for a few years, with entrepreneurs cutting corners and "consuming capital" (i.e., postponing necessary replacement and maintenance on equipment) while both investment and consumer goods keep flowing out of the pipeline at increased rates. But the music eventually stops, since (after all) the Fed's printing of green pieces of paper doesn't really make a country wealthier. When the Fed "cuts interest rates" it isn't really creating more capital for businesses to borrow; it is instead distorting the signal that the market interest rate was trying to convey.What Krugman fails to understand about booms is that they are not sustainable. The occur precisely because of malinvestments caused by government monetary (and sometimes fiscal) policies. Furthermore, government compounds the problem by trying to prop up the failed sectors, throwing good resources into a financial black hole, instead of permitting the failed sectors to be liquidated or transferred to other uses and to let the proper proportions of the economic fundamentals to get back into balance.
However, with Keynesians, because all factors of production are homogeneous, there is no need to get factors into balance, since they always are in balance, anyway. Thus, in the Keynesian view, we just need stimulus forever.
Now, there is one problem that Krugman has created for himself, and it is this: If factors of production behave the way he says they do, and if booms always can be sustained through government spending, then why are there financial bubbles? If there are no proportions that get out of balance, why could not the housing boom have gone on indefinitely? Krugman's theories simply cannot answer that question, except to say that capitalism is bad and needs to be regulated by government.