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.

Jobs, jobs and wealth creation

Mainstream economists like Paul Krugman have an administrative view of an economy, as though it can be managed centrally. All that matters in this viewpoint is the number of "jobs" that are created, and to Krugman and others like him, a hundred jobs "created" by government borrowing would be equivalent (and probably superior) to jobs created by a profitable business firm.

(And, since we are in a "liquidity trap," there is no opportunity cost, at least where government is concerned. One dollar of wealth creation is a dollar of spending, and so goes the circle.)

Furthermore, because he holds that an economy is basically a circular mechanism, he really cannot see beyond the number of employees a company might have employed in this country to see the value of what a firm produces. In his latest column, Krugman makes the point that Apple does not create many jobs, which is very, very short-sighted. He writes:

A big report in The Times last Sunday laid out the facts. Although Apple is now America’s biggest U.S. corporation as measured by market value, it employs only 43,000 people in the United States, a tenth as many as General Motors employed when it was the largest American firm.

In other words, in Krugman's view, Apple has no usefulness as a firm beyond how many people it employs. Its economic contribution stops at that point.

Firms do not exist to employ people; people are employed in the process of creating goods that are useful to others, and if one were to gain a sense of the real economic contribution of Apple, it would be safe to say that the company has created hundreds of billions of dollars of wealth, and Apple products and the technologies they have spun off have impacted the lives of billions of people. That's right, billions.

As for the point about "clusters," Krugman is correct at that point. Unfortunately, he shows his Keynesian colors here:

The point is that successful companies — or, at any rate, companies that make a large contribution to a nation’s economy — don’t exist in isolation. Prosperity depends on the synergy between companies, on the cluster, not the individual entrepreneur.

ut the current Republican worldview has no room for such considerations. From the G.O.P.’s perspective, it’s all about the heroic entrepreneur, the John Galt, I mean Steve Jobs-type “job creator” who showers benefits on the rest of us and who must, of course, be rewarded with tax rates lower than those paid by many middle-class workers.

In other words, entrepreneurs don't matter in the Krugman view of an economy. Of course, he forgets that one of this country's most important places of synergy, Silicon Valley, came about because of the vision of a few entrepreneurs who turned their ideas into the creation of huge amounts of wealth. Furthermore, he seems to forget that most of the great entrepreneurs of recent times have been...Democrats. From Steven Jobs to Bill Gates to Michael Milken to the founders of Google, liberal Democrats have made a huge economic impact because they had great ideas and how to put them together to create new products.

So, what is Krugman's idea of a Really Big Economic Success? The auto industry bailout. He writes:

...this vision helps explain why Republicans were so furiously opposed to the single most successful policy initiative of recent years: the auto industry bailout.

The case for this bailout — which Mr. Daniels has denounced as “crony capitalism” — rested crucially on the notion that the survival of any one firm in the industry depended on the survival of the broader industry “ecology” created by the cluster of producers and suppliers in America’s industrial heartland. If G.M. and Chrysler had been allowed to go under, they would probably have taken much of the supply chain with them — and Ford would have gone the same way.

Fortunately, the Obama administration didn’t let that happen, and the unemployment rate in Michigan, which hit 14.1 percent as the bailout was going into effect, is now down to a still-terrible-but-much-better 9.3 percent. And the details aside, much of Mr. Obama’s State of the Union address can be read as an attempt to apply the lessons of that success more broadly.

First, Krugman assumes that there are no other auto producers in this country, and I am sure that many of the assets of Chrysler and GM would have been put to good use. Second, Krugman forgets that the bailout did not occur in order to save "clusters," but rather to force taxpayers to pony up to save the United Auto Workers.

The reason that GM and Chrysler were bankrupt was that they were producing goods that consumers were not willing to purchase, and neither company was willing to do what was necessary to turn around the situation. Yes, they had intransigent unions and delusional managers, but that did not mean that the rest of us should have been forced to cover for them. Chrysler and GM were destroying wealth, not creating it, and by rewarding their actions, the Obama administration sent a strong message that the only thing that matters in this economy is a political connection.

Krugman has no idea how markets work and he certainly does not understand a price system. (Sorry, aggregate supply and aggregate demand models have nothing to do with price systems or even economics.) Once again, we see that he really does not know what wealth creation means and cannot differentiate between a job that creates wealth and a job that destroys it.