As predicted, many of the comments to my Austrian economics post are of the form “Well, of course employment rises when investment is expanding, and falls when the investment is falling — in the first case the economy is booming while in the second it’s slumping.”Actually, Austrians have explained this issue, but Krugman is not going to listen, and his way to argue is to create a straw man and then claim it is the real thing. The thing to keep in mind is that during a boom, there is malinvestment going on, not "more investment." There is a huge difference.
As I tried to explain, however, that’s assuming the conclusion; there’s no “of course” about it. Why do periods when the economy is investing more correspond to booms, while periods when it’s investing less correspond to slumps? That’s easy to understand in Keynesian terms — but the whole Austrian claim is that they’re an alternative to Keynesianism. Yet I have never seen a clear explanation of this central point.
Austrians are saying that when government artificially holds down interest rates (something Krugman supports), investments are moved into areas that correspond well to the change in time preferences that are reflected when interest rates fall in a free market, due to increases in savings. However, when the government engages in artificially lowering the rates, then the investments do not match the spending patterns of consumers, and ultimately a crisis occurs, followed by a bust.
Krugman, on the other hand, believes that it is good for government to hold down the rates, but then apply regulation to stop potential bubbles. Here he is in his own words:
But did I call for low interest rates? Yes. In my view, that’s not what the Fed did wrong. We needed better regulation to curb the bubble — not a policy that sacrificed output and employment in order to limit irrational exuberance.This is more telling -- and more contradictory to the Keynesian arguments than what Krugman will admit, for he is hinting that low interest rates can lead to a bubble, which is what Austrians would call malinvestments (or maybe malinvestments on steroids). However, he believes that government can head off such malinvestments through regulation.
This is very interesting, for on one hand, he claims that it is all aggregate demand, but on the other hand, he is saying that forcing down interest rates can have consequences if government does not try to regulate away the excesses. However, he cannot have it both ways. Indeed, he is accusing us of employing back-door Keynesianism, but then tries to do the same with Austrian theory.