Thursday, November 29, 2012

Are the Austrians Wrong?

Paul Krugman is at it again with the Austrians, creating straw men and then shooting down the arguments that they never made in the first place. Today, he goes after Peter Schiff, who actually did a very good job warning people about the housing bubble. Of course, in the process of supposedly discrediting Schiff, he discredits himself, too.

Krugman writes:
Now, the thing about Schiff and all the other Austrians predicting runaway inflation is that they were right to make this prediction given their model. If you believe that a recession is caused by a failure on the production side of the economy, the result of past malinvestment or something, you should also believe that any attempt to correct this decline by expanding credit will simply result in too much money chasing too few goods, and hence a lot of inflation.

By the same token, the failure of high inflation to materialize amounts to a decisive rejection of that model. (And no, it’s not because the numbers are fudged; independent estimates don’t differ significantly from official inflation.)

First, I agree that since the increase in the monetary base has come about by expanding bank reserves, the only way the new money will move into the economy will be through a huge expansion of loans, which has not happened. Yes, much of that new money has gone into government bonds, but we have to remember that much of what is raised through government bond auctions is used to pay off previous bonds. (This is something the ancients once called "robbing Peter to pay Paul.") Even Austrians know that the new money has to circulate before it affects asset prices.

However, Krugman misses something that is obvious: The Austrians, including Schiff, recognized the housing bubble for what it was, a huge set of malinvestments. After all, if there are no malinvestments, there is no bubble. So, how could a theory that actually predicted the meltdown also be a bad theory, if we are to use Krugman's criteria for determining if a theory has validity or not.

Second, while we have seen significant price increases in food and fuel, and these increases come in part because of the continual debasing of the dollar. What we have not seen has been hyperinflation and I agree with Krugman that this is because the economy is depressed. No one in the Austrian camp would deny this.

Third, the very fact that we have had massive malinvestments that cannot be supported by the market certainly is going to bring a downward effect on the economy and on prices. Furthermore, with government moving vast amounts of money to prop up the failing housing market, not to mention subsidizing "green energy" and banks, why should we be surprised that there is a huge lack of economic growth?

However, understand that Krugman also has called for government measures that would vastly expand the rate of inflation, that being his call for the Federal Reserve System to be the primary buyer of U.S. short-term securities, something that for now is prohibited by law. (Krugman claimed that a "clever lawyer" could find a way to re-interpret the law, and I am sure he is right, given how the government has re-interpreted other laws to fit the interests of politicians.)

If that were to take place, then there is no doubt we would see massive inflation as the bond sales would be financed almost entirely by new money, which then would be spent by the government. Krugman pretty much said the same thing in his Monday column, claiming that government can just print its way out of this morass without any real consequences, since inflation would "be good for the economy."

There is one thing that troubles me whenever Krugman claims that Austrians are willfully blind because they have not bowed to Krugman's demands that they declare the Austrian Theory of the Business Cycle to be invalid, and it is this: If real increases in government spending, massive Fed purchases of both private and public securities, and vast subsidies given to "green" industries, along with a huge auto industry bailout have not produced a robust recovery, then should not Krugman also take a hard look at his model?

(Yes, yes, I know. Krugman says that the problem is we have not had enough government spending, enough taxation, enough printing, enough borrowing, and, of course, enough inflation. After all, Krugman is a strong believer in the post hoc ergo propter hoc fallacy of inflation and economic growth, and despite historical evidence to the contrary, Krugman is not going to abandon what seems to be his real religion.)


Dennis said...

Anyone who grew up in the 1970's will be well aware of the negative consequences of high inflation. But the seeds for this inflation were sown back in the early 60's with LBJ's welfare/warfare state. Inflation got another boost with Nixon's abandonment of the gold standard, which was a response to foreign creditors ditching the dollar for gold because of fears of, well, inflation. The full impact of inflation was also delayed with wage and price controls, so the whole scenario from boom to bust took close to ten years to play out.

Today, the real cost of inflation is being expunged from the public mind with clever statistical tricks. It's also important to realize that inflation will show up in some sectors well before others, such as it is in current farmland prices, which are starting to jump up at previously unheard of rates. This trend is bound to have a negative effect on the broader economy at some time.

Anonymous said...

Professor Anderson, what do you think of how there were economists from other different economic schools that were also able to predict what happened in 2007 and 2008 and their explanations? You've done a great job with the blog and I hope you can continue with it.

Tel said...

We still haven't see the student loans deleverage yet.

Housing has perhaps barely stabilized, but I doubt the banks are realistic about their portfolio values, so we still have to get through the markdowns at some stage.

Then supposing the economy does recover, the Fed would need an exist strategy -- how to stop all that money from rushing out all of a sudden.

Mike said...

You have hit the nail on the head of exactly the problem. We have $16.3T of debt at a current run rate to be $20T in four years. So let’s keep the math simple for illustration.

At present, average interest rate costs to the Treasury are around 2.5%. Long term historical average is a little under 6%. They have pushed the debt balance onto the short end of the duration curve so it turns over more quickly thus exposing the refi to interest rate changes.

$20T @ 5% equals $1T in interest costs alone. Interest, Social Security and Medicare will consume 100%+ of revenues.

So exactly how is the Fed going to soak up all of that liquidity without blowing up the budget?

Inquiring minds want to know

Tel said...

... and if interest on Treasury debt blows out the deficit, they will just sell more bonds right? Which in turn puts pressure on interest rates to rise, which blows out the deficit even more.

The Fed won't allow that to happen so QE∞ and then we get back to money printing and inflation which is what those interest rates were supposedly keeping under control.

The only things holding back inflation are: delinquent loans; bankruptcy; asset markdowns; and private debtors actually paying down their debt.

Anthony Lima said...

Just try making sense of economics from PKs writing. He doesn't have a coherent model for how it all works. Maybe nobody does, but at least Austrians have the hubris to recognize proper scope and limits of the constructions they use.

Will "take no prisoners" Hart said...

You nailed it. This country has been doing demand-push stimulus for close to a decade now; Bush's wars, Bush's stimulus, Obama's stimulus, Obama's omnibus, the auto bailout, multiple extensions of unemployment compensation, 2 payroll tax holidays, a 50 increase in food stamps, Cash for Clunkers, etc., etc. and all that Paul Krugman can say is more.

Tel said...

Pondering this further, there is an additional factor which could keep inflation under control -- raising taxes. Of course, there's no point taxing the poor, they have nothing worth taking (Willie Sutton's Law) and you can tax the rich but that won't be enough, so what it is going to come down to is taxing small business, and the somewhat upper middle class.

In the immediate case, tax sops money out of the economy, but more than that it suppresses business activity and so lowers the velocity of money. That double-effect can be used to stop the inflation getting out of control.

Problem is, that discouraging business activity is putting you back into recession again... but look in theory it could be "managed", presuming no one cheats, lies or just blunders.