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Cycle Debate

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12/02/1998Gene Epstein

Austrian business cycle theory has become the subject of a raucous debate. It began with an article by Austrian journalist Gene Epstein, writing in Barron's about the work of Keynesian Paul Krugman of MIT. Krugman blasted back in the pages of Slate with a hit on the Austrians that fails to fully understand the theory.

Excerpts follow:

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Gene Epstein from Barrons (Nov. 9, 1998):

A couple of weeks ago, when I visited Krugman in his office at MIT in Cambridge, Massachusetts, the economist was hunched over his word-processor, but paused to greet me cordially, then begged a few minutes to finish his work....

An undergraduate economics major at Yale, then an economics doctoral student at MIT, a former staff member with the Council of Economic Advisers under President Reagan and now the Ford International Professor of Economics at the institution that trained him, Krugman struck me at the end of the day as not quite any of these things. Rather, he seemed more the Long Island high school student he once was-the Smartest Kid in the Class, accustomed to getting attention for wit and insight.

I did have some conceptual bones to pick with him, and over the course of the afternoon he responded with good humor and even at times gave a little ground -- such as on his long-held opinion about the speed limits on economic growth. But on one point, he stone-walled.

I objected to his having written that, before John Maynard Keynes came along, the world's understanding of recessions was "in a state of arrested development." Wasn't he familiar with the Austrian theory of business cycles, as set forth by Ludwig von Mises, Friederich Hayek and their American disciple, Murray Rothbard? He allowed that he wasn't, implying that such ideas were off his radar screen, since they couldn't be expressed mathematically.

In fact, however, the Austrians wrote brilliantly about the supply-side, and what they had to say is quite relevant to an understanding of the global slow-down.

Take Krugman's creative Keynesian-style solution for curing Japan's ills. He proposes that the central bank flood the system with money, to induce inflation. Then, the rate of price rise will exceed the cost of credit, bringing the much-needed magic of negative real interest rates (a condition in evidence last week, when investors in Japan were paying prices for six-month Japanese treasury bills that ensured negative yields). And when the price of funds gets into minus territory, both business and consumer will be induced to borrow again.

That's a demand-side approach with a lot to say for itself, but it ignores supply-side problems. For example, High Frequency Economics chief economist and Japan-watcher Carl Weinberg says he welcomes Krugman's proposal, but speaking as a "practitioner" -- meaning that he sees things that academics don't -- he believes that certain steps must be taken before such concepts can take effect. First, he says, deal with the problems of the banking system and its gargantuan burden of non-performing loans, lest the monetary expansion be for naught.

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Paul Krugman writing in Slate (December 3, 1998):

A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the "Austrian theory" of the business cycle--a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire. Oh well. But the incident set me thinking--not so much about that particular theory as about the general worldview behind it. Call it the overinvestment theory of recessions, or "liquidationism," or just call it the "hangover theory." It is the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion.

The hangover theory is perversely seductive--not because it offers an easy way out, but because it doesn't. It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love.

Powerful as these seductions may be, they must be resisted--for the hangover theory is disastrously wrongheaded. Recessions are not necessary consequences of booms. They can and should be fought, not with austerity but with liberality--with policies that encourage people to spend more, not less. Nor is this merely an academic argument: The hangover theory can do real harm. Liquidationist views played an important role in the spread of the Great Depression--with Austrian theorists such as Friedrich von Hayek and Joseph Schumpeter strenuously arguing, in the very depths of that depression, against any attempt to restore "sham" prosperity by expanding credit and the money supply. And these same views are doing their bit to inhibit recovery in the world's depressed economies at this very moment.

The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand. Maybe excessive money creation or reckless bank lending drives it, maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. Whatever the reason, all that investment leads to the creation of too much capacity--of factoriesthat cannot find markets, of office buildings that cannot find tenants. Since construction projects take time to complete, however, the boom can proceed for a while before its unsoundness becomes apparent. Eventually, however, reality strikes--investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover.

Except for that last bit about the virtues of recessions, this is not a bad story about investment cycles. Anyone who has watched the ups and downs of, say, Boston's real estate market over the past 20 years can tell you that episodes in which overoptimism and overbuilding are followed by a bleary-eyed morning after are very much a part of real life. But 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? Don't say that it's obvious--although investment cycles clearly are associated with economywide recessions and recoveries in practice, a theory is supposed to explain observed correlations, not just assume them. And in fact the key to the Keynesian revolution in economic thought--a revolution that made hangover theory in general and Austrian theory in particular as obsolete as epicycles--was John Maynard Keynes' realization that the crucial question was not why investment demand sometimes declines, but why such declines cause the whole economy to slump.

Here's the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods--implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?

Most modern hangover theorists probably don't even realize this is a problem for their story. Nor did those supposedly deep Austrian theorists answer the riddle. The best that von Hayek or Schumpeter could come up with was the vague suggestion that unemployment was a frictional problem created as the economy transferred workers from a bloated investment goods sector back to the production of consumer goods. (Hence their opposition to any attempt to increase demand: This would leave "part of the work of depression undone," since mass unemployment was part of the process of "adapting the structure of production.") But in that case, why doesn't the investment boom--which presumably requires a transfer of workers in the opposite direction--also generate mass unemployment? And anyway, this story bears little resemblance to what actually happens in a recession, when everyindustry--not just the investment sector--normally contracts.

As is so often the case in economics (or for that matter in any intellectual endeavor), the explanation of how recessions can happen, though arrived at only after an epic intellectual journey, turns out to be extremely simple. A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time. Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it's not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?

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. Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives, who can't stand the thought that positive action by governments (let alone--horrors!--printing money) can ever be a good idea. Some libertarians extol the Austrian theory, not because they have really thought that theory through, but because they feel the need for some prestigious alternative to the perceived statist implications of Keynesianism. And some people probably are attracted to Austrianism because they imagine that it devalues the intellectual pretensions of economics professors. But moderates and liberals are not immune to the theory's seductive charms--especially when it gives them a chance to lecture others on their failings.

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For Epstein's response, click here.

Also see Roger Garrison's compelling critique here.

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