Uh, Isn't this a Case of Malinvestment? I Forgot; Krugman Doesn't Believe in Malinvestment

A while back, Paul Krugman mocked the Austrian Business Cycle Theory (ABCT -- or ATBC), claiming it was akin to the "phlogiston theory of fire." Why would he use such terms? Because the ABCT is based on the view that government economic intervention -- and especially aggressive monetary intervention -- creates malinvestments that cannot be sustained, and every good Keynesian knows that the real problem is "aggregate demand."

Thus, to get an economy quickly back on track after a bout of poor aggregate demand, all that is needed is for a government to engage in aggressive spending, borrowing, creating inflation (when the economy is in a "liquidity trap"), and creating vast subsidies in order to ramp up more spending. Krugman has emphasized these points time and again the past four years, and they are part-and-parcel to Keynesian doctrines.

Yet, in his most recent column, Krugman tries to claim that a financial crisis is "different" from other business cycle downturns because it takes longer for the economy to recover. Yet, to me, this brings up a number of questions that seem to contradict his Holy Keynesian Faith. He writes:

... President Obama’s people failed to appreciate something that is now common wisdom among economic analysts: severe financial crises inflict sustained economic damage, and it takes a long time to recover. (emphasis mine)

The simply question I ask is: Why? For that matter, given the Keynesian view that for analytical purposes factors of production are homogeneous, why should a housing bubble be a bad thing? (Oh, I forgot, the Federal Reserve System is trying to reflate the housing market and Krugman approves. That's called creating another bubble.)

If a housing bubble, or any other financial bubble, puts prices out kilter with fundamentals, why is that a problem given that Keynesian doctrine treats an economy simply as two curves, an aggregate demand curve and an aggregate supply curve? No matter what the government does as long as it encourages more demand is just fine.

Does Krugman believe this? No, or at least if he recognizes financial bubbles, then he also recognizes malinvestments, even if he claims otherwise. However, in looking at his infamous "Hangover Theory" article, there is a contradiction that Krugman never has tried to erase. He writes:

...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?

However, during both the Tech Bubble and the Housing Bubble, unemployment rates did go down and we had a general economic boom. (The Clintonistas claimed that they had created a "New Economy" by raising the top tax rate to 39.6 percent.) The booms were the trigger mechanism for much of the creation of new money and were central points of spending. Furthermore, the U.S. dollar was considered to be the world's "reserve currency," so when people were able to hold more dollars, the rest of the world was glad to accept them.

Even Krugman would acknowledge that point, but he has no intellectual theory to explain why it is that a housing bust and financial crisis should then result in long-term economic damage complete with high unemployment. His criticism of the ABCT could just as well be criticism of his own Keynesians beliefs:

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.

We could say the same thing about Keynesian Theory and Krugman's earlier point about financial collapses. If government simply takes over all lending and spends and spends and spends, then why should there be any residual problems at all? In fact, the government has done all of these things, yet the underlying economy is very weak. Krugman can try to play the political operative and spin the current mess as a huge success for the Obama administration, but he has not explained how a financial bubble (1) could help create a boom and (2) how a bursting of the bubble would cause damage given that government can fix things with spending.

Furthermore, if prices really don't matter (except aggregates put into an index), how would we know in the first place that a bubble had occurred? So what if housing prices are high; if the relationship of the prices don't really matter, then who is to say that housing is out-of-kilter? No doubt, these statements will enrage a Keynesian True Believer, but Keynesians -- including Krugman -- are not free to claim that prices matter when they want them to matter and that prices don't matter when Keynesians claim they don't.