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.

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.