Robert Murphy Takes On Krugman's "Hangover Theory" Caricature

In recent blog posts, Paul Krugman has been claiming that the Keynesian paradigm has been vindicated by recent employment and financial statistics, but that officials foolishly are listening to the "hangover theory" nonsense.

Since Krugman does have a perch at the NY Times, he is able to control his side of the debate, but he cannot control the facts. Robert Murphy, who in my view is a much better economist than Krugman ever will be (given that Krugman has decided that being a political partisan is much more fun -- and lucrative -- than being an economist), demonstrates that two can play the graph game.

In a recent post on the Mises site, Prof. Murphy takes on Krugman's contention that the breakdown of employment numbers "proves" his points correct. First, he posts a graph used by Krugman that "proves" that the downturn is due to a general fall in "aggregate demand," as opposed to problems within the structures of production (as Austrians maintain). (I post the graph below, including Krugman's explanation):

I tried, in that old piece on hangover theorists, to explain what's wrong with this view in general. Among other things, "this story bears little resemblance to what actually happens in a recession, when every industry — not just the investment sector — normally contracts."

And this is strikingly true this time around. Kocherlakota would have us believe that there's a big problem of mismatch because manufacturing is trying to hire, while construction has slumped. But here's the employment reality:

Manufacturing employment has slumped, not risen — in fact, it has fallen more than construction employment. The problem is lack of overall demand, not worker mismatch.

However, Prof. Murphy does what any good economist should be doing: breaking down the data to see what trends lie in numbers dehomogenized from their aggregates. He writes:

First of all, Austrians can easily explain why there is a general drop in employment after a bubble pops, rather than just drops in (say) capital-goods industries. The problem in the aftermath of a bubble isn't merely that a "given" level of demand switches from one sector to another. On the contrary, people in general are poorer than they thought they were at the height of the boom.

In particular, during the boom, people unwittingly consumed capital. In a simplistic Keynesian model with "no time and no capital," it's not surprising that Krugman finds the Austrian story nonsensical. But as I spelled out in my "sushi article," a distortion in the interlocking capital structure of a modern economy can quite obviously lead to a general rise in unemployment across many sectors, as the mistaken investments are flushed out of the system.

Prof. Murphy then directly takes on the employment issue by noting that a breakdown of employment in construction trades and in durable and non-durable goods does demonstrate -- contra Krugman -- that the kind of employment shifting that Austrians would predict actually has happened. The graph is shown below:

Add Prof. Murphy:

I submit that the above chart is entirely consistent with the Austrian explanation of business slumps following an unsustainable boom period. Contrary to Krugman's misleading chart, in percentage terms the construction sector has taken a larger hit than "manufacturing" in general, and construction has been brutalized compared to the mild downturn in nondurable-goods manufacturing.

Moreover — and this is presumably what motivated Kocherlakota's comments — a naive extrapolation of year-to-date trends suggests that the manufacturing sector has bottomed out and is on the road to recovery. Construction employment, on the other hand, is still falling.

The Austrians can easily interpret the above chart. How does Krugman? If the recession is really just about falling aggregate demand, then why did construction fall so much more than nondurable manufacturing, and why has durable manufacturing risen in 2010 while construction still languishes?

I'm not always enamored with the "my statistics are better than your statistics," but I do think that Prof. Murphy has added some important things to the current debate. Now, I doubt that all the statistical "proof" in the world would dislodge Krugman from his position, but at least I can appreciate someone like Bob Murphy who takes on Krugman at the very points where the Princeton Prof believes he is triumphant.