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Source link: http://archive.mises.org/10379/hangover-theory-how-paul-krugman-has-misconceived-austrian-theory/

Hangover Theory: How Paul Krugman Has Misconceived Austrian Theory

July 31, 2009 by

Paul Krugman is an eminent economist, but he reveals a woefully inadequate understanding of Austrian business-cycle theory. The rudiments of the theory are easy; one might have thought that even a Keynesian could grasp them. FULL ARTICLE

{ 36 comments }

Larry N. Martin July 31, 2009 at 10:26 am

The Fed Chair goes into this bar, you see, and loaded with a bunch of newly printed money, offers to buy everyone a drink. Good Times! Everybody rushes up to the bar to get a free drink. Unfortunately, he forgot that the bar only has so much liquor available, and while the firstcomers get nice, big glasses of new drinks, the bar eventually starts running out of alchohol, and the latecomers end up getting nothing.
Thus, Krugman’s so-called “hangover theory” isn’t even an accurate description of the problem, because only some people will get hangovers, while others will never experience the “irrational exuberance” of drunkeness in the first place, and will have to go home quite sober.

Eric July 31, 2009 at 10:27 am

The “rational” for Krugman’s misunderstanding presumes intellectual honesty on the part of Krugman.

But this “economist” makes his living as a government cheerleader. Nobody can know what’s truly in his heart of hearts, but I suspect that he sees his own self interest in promoting government intervention, and would quickly see his status as a court economist vanish were he to embrace Austrian policies that government should simply stop what it’s doing.

To this end, he likely convinces himself that his theory is as good as any other, and since it does benefit him greatly (e.g. Nobel Prize) just like a Pavlovian dog, he licks his chops at every opportunity to embrace the state-ist quo.

flix July 31, 2009 at 10:27 am

I’d absolutely love to see Krugman debating an austrian… the challenge should be posed! His (likely) refusal heavily publicized..

libertyman July 31, 2009 at 11:09 am

Agreed, it would certainly throw his credibility down the gutter if he were to debate an Austrian in a nationally televised event. They should have a Peter Schiff x Paul Krugman round one, followed by a Barak Obama x Ron Paul round two.

There have been a couple other Mises articles slamming Krugman’s interpretation of the ‘Hangover Theory’ – I wonder if Krugman has come across these (does he even know of Mises.org)? I would love to see Krugman attempt to rebutt them.

There only seems to be one minor problem with this article, and is a mistake I have seen committed by other Austrian economists. Gordon states “Since more money is available, the price of money goes down”. Keyenes famously argues that interest rates are basically the price of “parting with liquidity”. The Misean position is that interest rates are purely the result of time preferences – in other words, the price of time.

Arend July 31, 2009 at 11:33 am

Argument with nice form but lack of substantiality follows: It is curious to see a Nobel Laureate on a subject that is totally remote from business cycle theory rejecting – pretty much on face value and without much thought – a business cycle theory that won Hayek – and de facto Von Mises posthumously – a Nobel Prize.

Rick July 31, 2009 at 12:05 pm

“the good professor proposes, a freewheeling policy should be adopted. Why not expand the money supply and avoid depression altogether?”

Yes of course, I mean why shouldn’t we print money to avoid a depression? Hell, if creating wealth out of thin air is so wonderful in a depression, why can’t we do it during the good times as well? Why stop there? As Peter Schiff says, why don’t we all just stop working and have our own little printing presses in our homes.

Now that would be fantastic!

Ohhh Henry July 31, 2009 at 12:30 pm

Heh … the “pkarchive” hosting the article linked above has not caught on yet as a hotbed of knowledgeable economic debate. I went to its message board expecting to see Austrians and Keynesians duking it out and all I found were spam advertisements for fish finders and dating websites.

I guess it’s a work in progress, as the “Others on Krugman” page does not yet provide any links to articles at mises.org.

C July 31, 2009 at 12:36 pm

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.

There seems to be an even more basic fallacy in Krugman’s logic, besides the assumption that changes in consumers’ or investors’ spending for investment will cause a consumption boom.

“Total spending” cannot equal “total income” when the Fed magically creates $300billion and buys govt bonds, so that the govt can spend that $300billion and expand the deficit. Total spending is now at least $300B more than total income. No consumer earned that $300B and they are not spending it on plasma TV’s or Detroit automobaubles. Instead, the spending is on things the govt wants, but that consumers would have not been likely to buy if it were their income to spend. Even if they eventually pay back the $300B in inflation and future taxes, the short-term equation does not balance.

Therefore, to claim such a simplistic equation, total income = spending + investment, and not include inflationary money creation driving deficit spending, is to completely misunderstand (or intentionally misrepresent) the ABCT explanation as “simple arithmetic” at a static point in time, rather than a praxeologic analysis of the consequences of monetary actions.

Is Krugman stupid or evil?

Econ Guy July 31, 2009 at 1:08 pm

“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?”

According to Keynesian theory, investment and consumption always move up and down together. C and I always move in the same direction. This result is found in Roger Garrison’s “Time and Money”: C = a/(1-b) + b/(1-b)I. Either Krugman doesn’t understand Keynesian theory, or he’s being dishonest.

Toby July 31, 2009 at 1:09 pm

Isn’t there another target for your frequent attacks on Keynesians than Paul Krugman? It starts to get annoying seeing his ugly beard twice a week on mises.org.
How about Joe Stiglitz’ ugly beard? For sure, he does deserve some attention, too!

Emil Suric July 31, 2009 at 1:29 pm

“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?”

Wow, talk about confusion! So-called ‘consumption booms’ are nonexistent; consumption means a consolidation in the structure of production, towards a less capitalistic (roundabout) production process. When are Keynesians going to consider the structure of production? Or the fact that capital is heterogeneous and complementary? There exists a division of labor and of capital, the latter being just as important as the former, if not more important. Furthermore, there is a certain degree of capital destruction/consumption during this process, and therefore a reduction in productivity per worker. You’d think they’d eventually stop and read some Austrian literature?

Ned Netterville July 31, 2009 at 2:08 pm

I cannot allow David Gordon’s characterization of Paul Krugman as “an eminent economist” to go unchallenged. As the recipient of the 2008 Nobel prize in economics, and as a writer on economics for The New York Times and Fortune, he is unquestionably well known, or, shall we say, popular. He is also, no doubt, beloved by politicians and bureaucrats for providing them with an “economic” rationale for their unsavory penchant for spending OPM (other people’s money). But, at least for me, eminent economist implies someone whose work in the economic science is both high in quality and honorable. These are not traits I attribute to Mr. Krugman’s work.

In his NYT op-ed column of November 10, 2008, Krugman wrote, “What saved the economy, and the New Deal, was the enormous public works project known as World War II, which finally provided a fiscal stimulus adequate to the economy’s needs.”

In order for the word “analysis” to be modified by the word “economic,” it must look beyond the plainly visible in any situation to see the less- prominent consequences. But the “full employment” finally realized in the United States after more than a decade of failure of Keynesian economic policies to ameliorate unemployment, which was their stated objective, the full employment in the US during WW II cannot obscure from even the blind or ignorant the following striking facts: that the depressionary slack in US employment was partly relieved by forcing young Americans into military employment where many of them were to be killed; that many more of the depressionary unemployed, including many women who deprived their children of a full-time mother in order to work, were hired to produce otherwise useless war materiel that was destined to be destroyed and add nothing to the nation’s wealth; that the standard of living of many US citizens who were not being killed overseas was reduced below depression levels in terms of consumption preferences by government rationing of the most desirable consumer goods; that real investment assets were being destroyed by bombs and bullets throughout Europe, Asia and the Pacific islands at a rate unmatched by all the natural disasters of many previous centuries. These are but a few of the more prominent economic consequences of World War II that Professor Krugman, like a carriage horse wearing blinkers to avoid the distraction of traffic, fails to see when he refers to that war as a ” public works project” and as a “fiscal stimulus adequate to the economy’s needs.”

Nathan Mayer July 31, 2009 at 2:10 pm

with no disrespect to Schiff, it’s a shame he is seen as the ultimate in Financial Austrian economics when there are far more eloquent and sophisticated Austrians such as James Grant, David Tice and Frank Shostak.

Vanmind July 31, 2009 at 3:30 pm

He’s getting desperate because he understands that he has lost the debate. Soon will come the ultimate in desperation: “Obey government or suffer the wrath of self-professed philosopher kings.” Then probably another Luciferian Award — I mean, Nobel Prize.

Bill Anderson July 31, 2009 at 3:45 pm

The thing to remember about Krugman is that he constantly shifts the goalposts. This guy is not about promoting sound economic theory; he is about promoting himself and Keynesianism, which is his religion.

Krugman wrote this piece in 1998 when he still had some respectability, or at least when some people still remembered his trade theory. However, since then, he has become a full-blown socialist and has used his perch at the NY Slimes to promote bad economics but, as always, to promote Paul Krugman.

It is not that one could explain this theory to Krugman and, perhaps, he then would understand it. No, he always manages to present a caricature of an opposing thought, as the guy is not willing to engage in honest debate.

Remember this: Krugman not only is evil, but he also is NOT, I repeat, NOT an economist. He is a political operative first and foremost.

Bill Anderson July 31, 2009 at 3:46 pm

The thing to remember about Krugman is that he constantly shifts the goalposts. This guy is not about promoting sound economic theory; he is about promoting himself and Keynesianism, which is his religion.

Krugman wrote this piece in 1998 when he still had some respectability, or at least when some people still remembered his trade theory. However, since then, he has become a full-blown socialist and has used his perch at the NY Slimes to promote bad economics but, as always, to promote Paul Krugman.

It is not that one could explain this theory to Krugman and, perhaps, he then would understand it. No, he always manages to present a caricature of an opposing thought, as the guy is not willing to engage in honest debate.

Remember this: Krugman not only is evil, but he also is NOT, I repeat, NOT an economist. He is a political operative first and foremost.

ffi July 31, 2009 at 6:20 pm

Someone might want to improve the wiki article then and add an explanation why Krugman’s critique is wrong:

“Nobel laureate Paul Krugman also made a similar argument when he stated that the theory implies that consumption would increase during downturns and cannot explain the empirical observation that spending in all sectors of the economy falls during a recession.[10]”

http://en.wikipedia.org/wiki/Austrian_business_cycle_theory#Critiques

matt at anarchyjapan.com July 31, 2009 at 8:09 pm

Krugman states: “Whatever the reason, all that investment leads to the creation of too much capacity …”

Is this necessarily true? Isn’t this similar to saying there is generalized overproduction, which is a myth?

That is, malinvestment does not equal excess capacity, right? Or at least what does Krugman mean by excess capacity?

Bob Roddis July 31, 2009 at 9:51 pm

Has anyone EVER found a critic of the ABCT who understood any substantial aspect of the theory such as the so-called “Cantillon Effects” and/or how central bank monetary dilution must invariably distort the complex investment and capital structure? I submit that ABCT critics suspect that there might be something to the ABCT but intentionally avoid any attempt at understanding what that might be.

The actions of Krugman and most every critic of the ABCT are like that of an ostrich: They bury their heads in the sand so that they will not see or hear disturbing things. They deliberately avoid acquiring unpleasant knowledge that might suggest to them that their worldview is quite wrong.

Troy Camplin August 1, 2009 at 12:04 am

I am always astonished at the economic ignorance of Krugman. He should have read my blog posting back in April:

http://zatavu.blogspot.com/2009/04/interest-rate-manipulation-and.html

Then he could have understood what happened.

fundamentalist August 1, 2009 at 7:50 am

Troy, Krugman isn’t ignorant. He’s dishonest. The only way he can maintain his devotion to socialism is to be dishonest.

Arend August 1, 2009 at 10:41 am

My take on Krugman’s use of the phrases “for whatever reason” is that is lays in his a priori rejection of a priori theories such as the misallocation of capital as the result of unnaturally low interest rates. For Krugman, only interplay between aggregates (going up/down relative to one another) can be subject in sound economic theory.

Whatever the reason of this rejection (cognitive dissonance, mainstream peer pressure – which he uses himself and maybe still is subject off as well, cluelessness, dishonesty), it’s very obvious and it should be to mainstream economists as well.

Troy Camplin August 1, 2009 at 2:32 pm

I try to be generous and assume the best of people. If good is knowing the right thing, and doing it, and bad is not knowing what the right thing is, and doing the wrong thing out of ignorance, and evil is knowing what the right thing is and doing the wrong thing anyway, then that leave us with two options with Krugman: he either is ignorant, as I accused him, and he’s a bad economist, or he knows what the truth is and is lying and spreading misinformation on purpose, which makes him evil. I generally try not to accuse people of evil unless I know for certain they are purposefully misleading. Thus, I assume him to merely be ignorant, irrational, and stupid.

fundamentalist August 1, 2009 at 3:31 pm

Troy, It’s good that you are so generous to others. That’s very commendable. But I can’t see how Krugman can be ignorant. He has a PhD in economics and has won the Nobel Prize. It appears that he has read at least some Austrian economics. Either he didn’t understand it, which is unlikely given his background, or he deliberately distorts it. Krugman is either ignorant or a liar, and I know for a fact he isn’t ignorant.

Arend August 1, 2009 at 5:06 pm

fundamentalist: you actually leave one possibility unmentioned. As a Keynesian and liberal there is the possibility that Krugman just only believes in political action and not in the social sciences at all which may mean that he thinks along the lines of (reformulating Marx’ famous line): “‘Economists have hitherto only interpreted the world in various ways; the point is to change it’”.

In this kind of view there is no room for something like the ABCT, and there are many (illegitimate and inconsistent) arguments for that. Among other things it’s obvious fame and power are deluding his already limited judgement since he won the Nobel.

DJF August 2, 2009 at 8:27 am

“”””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?. “”””

The problem is that the economy does not run on simple arithmetic. For one thing the boom that occurred was suppose to have been paid for by future profits, yet these profits did not occur so that means that spending did not equal income. You can slap a “luxury” label on any house or condo you want but unless someone pays a luxury price for it then the expected profits are not going to occur.

And getting the government to spend tax dollars does not mean that we will get an increase in wealth either considering how much government spending is wasteful and even destructive of wealth. Buying up working automobiles and scrapping them does not make the USA richer, it makes it poorer since you turn a $4,000 car into a couple of hundred dollars in scrap.

Finally those who attack the need to liquidate bad investments as a hangover theory which is based on moralizing against those who made bad investments even get that wrong as well. Hangovers are not based on moralizing but on medical fact, you get a hangover by drinking to the point where your body has a negative reaction, there is no moralizing involved in that. It is biology. Just like if you make bad investments you need to liquidate them, there is no moralizing, it is economics. Having a condo which you cannot sell at $600,000 means you need to lower the price until you can sell it.

Bruce Koerber August 2, 2009 at 8:26 pm

Undoing Socialism
Wednesday, July 22, 2009

Krugman Is A Keynesian And A Socialist And A Charlatan!

We mustn’t forget that Keynes was a closet socialist. Krugman on the other hand is openly a socialist although he would try to paint himself as a disinterested academic.

They are both charlatans, ego-driven interventionists, and the scum on the surface of the ocean that will eventually be discarded and forgotten once mankind leaves behind these, the Dark Ages of economics.

Daniel August 2, 2009 at 8:48 pm

Tyler Cowen has a hilarious piece on ABCT called “If I believed Austrian Business Cycle Theory”

At least he knew SOMETHING about ABCT

Daniel August 2, 2009 at 9:03 pm

If I believed in Austrian business cycle theory

1. I would think that Asian central banks, by buying U.S. dollars, have been driving a massive distortion of real exchange and interest rates.

2. I would think that the U.S. economy is overinvested in non-export durables, most of all residential housing.

3. I would think that we have piled on far too much debt, in both the private and public sectors.

4. I would think these trends cannot possibly continue. Asian central banks may come to their senses. Furthermore the U.S. would be like an addict who needs an ever-increasing dose of the monetary fix. This, of course, would eventually prove impossible.

5. I would think that the U.S. economy is due for a dollar plunge, and a massive sectoral shift toward exports. Furthermore I would think it will not handle such an unexpected shock very well.

6. I would buy puts on T-Bond futures and become rich.

7. I would think that Hayek’s Monetary Nationalism and International Stability, now priced at $70 a copy, is the secret tract for our times.

Of course that is not me. But at least someone appears to believe in Austrian business cycle theory. By the way, here is one summary of the theory, although I do not agree with the characterization in all respects.

Source: http://www.marginalrevolution.com/marginalrevolution/2005/01/if_i_believed_i.html (his f-ing blog)

Daniel August 2, 2009 at 10:32 pm

Note that Tyler wrote this in January of 2005

Ryan August 3, 2009 at 8:13 am

That’s a pretty ironic article, Daniel.

AndyH August 3, 2009 at 2:11 pm

Hey all,
even though I do think that Hayek put forward a nice theory of the business cycle that well describes this cycle (I agree with Gordons article), I think it is ignorant and wrong to call Krugman a bad economist or even a liar.
I am sure that he knows more about economics than most people here. The same is true for Bernanke who has published tons of papers on monetary economics and so forth. They are just drawing different conclusions because of a different set of assumptions than some liberal economists. This is the problem in economics. Why cannot market agents have be the cause of the crisis? Why do “Austrian extremists” assume this possibility away?
And of course there are also reasons for government interventions during crisis periods. People are not all stupid. A. Extremists just assume that government spending brings about worse outcomes than private investment, but worse outcome than no investment? Also this is not always the case. There may be a multiplicatior effect and there are public goods.
It is just silly that people having contributed nothing to economics post comments here and try to evaluate things they do not even understand.
But to the end, I also disagree with Krugman asking for more spending all the time. To my mind, fiscal expansions should concentrate on public goods like infrastructure, environment and so on.

Troy Camplin, Ph.D. August 5, 2009 at 12:52 am

Well, if Krugman is either a Keynesean or a socialist, I reiterate my argument that he is either incredibly ignorant of economics or, knowing economics, has evilly chosen what he knows for a fact to be bad.

Having a Ph.D. — or a Nobel Prize, for that matter — doesn’t mean much. I have met plenty of people in my own field who I could not believe any institute ever gave them a degree. And don’t make me list all the Nobel Prizes given out primarily for political reasons rather than the value of the work.

But if we choose to reject ignorance, that only leaves the option of Krugman as evil.

greg_w August 6, 2009 at 5:08 pm

David Gordon began: “Paul Krugman is an eminent economist,…”

I’m getting pretty sick of Krugman getting any deference at all. (He wasn’t always such a hack.) I have come to realize he has always been an *intellectual lightweight*, even if he once had some honesty and skill regarding technical matters of economics.

He deserves no deference — his “bank” account with me is empty.

The only reason to deal with such a nut is because a lot of other nuts listen to him.

“The demagogue is one who preaches doctrines he knows to be untrue to men he knows to be idiots.”–
H. L. Mencken

Pete August 7, 2009 at 8:35 am

I would like to ask a few questions about Krugman’s argument:

1. He says “Then every industry—not just the investment sector—normally contracts”. Depending upon the nature of particular consumer products made by various sectors, each sector should be more or less susceptible to malinvestment in the degree to which the round about means of production is technically possible. Is it feasible to identify examples these sectors? For example, perhaps the agriculture sector (which provides food – a consumption good) is less adversely affected in the bust than steel (which provides materials for production goods). If so, are inequalities in sector specific contractions in the recent recession consistent with this?

2. David Gordon well explains that “Unemployment … stems mainly from rigid wage rates”. Unemployment is increasing in this recession, so presumably wages rates are rigid. I am unaware of any present legal restrictions on employers reducing wages – what is presently restraining employers from reducing wage rates to permit lower unemployment?

Pete August 11, 2009 at 9:28 pm

Krugman’s shows remarkable ignorance of the Mises theory in stating “…implying that an investment slump should always be accompanied by a corresponding consumption boom”. For Mises had long ago well explained the reasons that this is false in Human Action, Chapter XX.

On page 556 Mises described investment and consumption as both increasing in the boom: “the boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment. The essence of the credit-expansion boom is not overinvestment, but investment in wrong line, i.e. malinvestment. … [Entrepreneurs] embark upon an expansion of investment on a scale for which the capitial good do not suffice.”

On page 575 Mises described consumption decreasing during the recession: “Wage rates must drop; people must restrict their consumption temporarily until the capital wasted by malinvestment is restored.”

Krugman ought to challenge those arguments which Mises actually offered to arrive at the conclusions quoted above, rather than criticize Austrian theory for being in error about a particular relationship between consumption and investment that it does not teach.

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