Neither Structure nor Aggregate Demand

The Paul Krugman theme over the past four years have been pretty consistent and, to be honest, easy to understand. Economies around the world, including our own, are hampered by a lack of what he calls "aggregate demand," or a lack of overall spending, and until those reactionaries and members of Goldstein's Army (the Very Serious People) are vanquished, economic stagnation will remain the norm.

In the Krugman view, there are two competing philosophies. The first is the Keynesian way of thinking, which is promoted by the Good People. The second is the "Structural Unemployment" group, which is run by monsters and worshipers of Goldstein. Since the Keynesian viewpoint is obvious in terms of accuracy and truth, the only reason others would hold to another way of thinking is because they are evil and enjoy watching others suffer.

There are some people, however, who hold to the "structural" view and at least Krugman is charitable toward Edward Lazear, who presented a paper at the recent Fed conference at Jackson Hole. Apparently, Lazear is an exception to the Krugman rule that anyone who disagrees with the Keynesian thesis is evil; Lazear only is misguided.

But what if there is a third theory out there, one that examines demand from a different point of view, and instead of saying that there is a mismatch between individuals and the jobs available lays the current mess at the feet of massive malinvestments that became exposed in 2007 and 2008, and then have grown in the intervening years, thanks to government spending and regulation. Yes, Krugman refers to the third view, the Austrian Theory of the Business Cycle as nonsense and then mislabels it a "hangover theory."

With all respect to Pete Boettke and the "Coordination Problem" group, the current situation in the economy is a classic Austrian example. The "structure" and "coordination" people do have a short-run point. That is, after the original set of malinvestments are exposed and abandoned, then there would be a short period of higher unemployment when the factors of production, including labor, are re-directed away from the malinvestments and toward those lines of production that would be profitable.

(In the classic Austrian view, the malinvestments generally occur in the lines of capital goods and away from consumer goods, as there is a "mismatch" between interest rates and the general time preferences of individuals, the "mismatched" caused by government or central bank intervention. The recession is the time when the factors are redirected to more profitable uses in line with individual time preferences within the economy. During that time, there are both "mismatches" and issues of coordination between labor and other factors.)

I agree with Krugman that the current situation is not in the "mismatch" camp, although even he admits that in the early days after the meltdown of 2008 there was some "mismatch" evidence. However, where Krugman and I part ways (if we ever were on the same path at all) has been government and Fed policies since that fateful September 2008. Krugman holds that government has not spent enough, regulated enough, or bullied enough, and that if Washington engaged in massive new spending schemes, such as preparing for imaginary "space aliens," all would be well.

The Austrians, on the other hand, believe that far from cleaning up the original mess, Washington simply made the mess even bigger. Keynesians, after all, do not believe that booms are periods when resources are pushed in the wrong direction and cannot be sustained. Instead, they believe that as long as government pours money into the economy, the boom can be sustained indefinitely. In fact, Keynesians hold that unless government ratchets up the spending, the economy will be mired permanently in depression because a market economy always moves toward under-consumption and stagnation.

In Keynes's view -- which coincides with Krugman's -- market economies (and especially the more complex and prosperous ones) are inherently flawed. Writes John H. Williams in a 1948 review of The General Theory:

It was not a coincidence, or a misinterpretation of Keynes, that the first great development of the theory by his disciples was the stagnation thesis, that the war was regarded as a superlative demonstration of what could be accomplished to sustain employment by a really adequate volume of effective demand, and that the weight of expectation of Keynesian economists was that we would relapse after the war into mass unemployment unless vigorous antideflation measures were pursued. There is no better short statement of the stagnation thesis than that given by Keynes: “The richer the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system…. Not only is the marginal propensity to consume weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive.”

Thus, wealth led to poverty because wealthier people were likely to save more, which would cause "aggregate demand" to spiral downward. It was as inevitable as a sunrise following early morning darkness.

Yet, let us count the ways that the government has intervened in this recession to turn it into a full-blown depression. First, the government has both pushed easy money policies AND pushed strict regulations against private lenders (while simultaneously trying to make lending easier in housing). Far from letting the worst of the malinvestments be permitted to be closed out, the government has tried to keep them going, using vast amount of resources in the process.

Second, it has poured hundreds of billions of dollars into "green energy" subsidies that are malinvestments on their faces. Government attempts to create electricity through wind and solar and has pushed inferior fuels such as ethanol that are much more costly than conventional methods and fuels, which means that hundreds of billions of private and tax dollars have been funneled into lines of production that are not and cannot be sustainable unless government intervenes even more and makes conventionally-produced electricity either illegal or so costly that only then puts the "alternative" sources on a level playing field. Some playing field.

Third, the Obama administration has continued the unwise bailout programs of the Bush administration, including the rewriting of contracts when it created "Government Motors." (I have no doubt that Bush, had he been in office, would have done the same thing, and it would have been the wrong thing.)

Keynesians believe that once resources become unemployed, they cannot become employed again in a market economy unless government intervenes first. That it is not true and history bears out that fact means nothing. After all, Keynesianism is a theory in which government intervention always is the solution.