Yes, Paul Krugman, Booms Are Unsustainable

(The best account of the Austrian theory is found in Murray N. Rothbard’s America’s Great Depression, whose first half Rothbard dedicates both to explaining the business cycle theory and also answering the Keynesian critics of the theory. One only wishes that Rothbard had lived long enough to respond to Krugman’s missives.)

With Keynesians such as Krugman, this process can go on indefinitely. True, some of the capital investments might not be sustainable, but that can be explained by the fact that there always are business fluctuations in the course of the economy. He writes:

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?

In other words, even if some capital investments go south, there is no reason for the economy to decline. After all, money has not disappeared, so if spending is halted on some unsuccessful capital investments, then consumers can just spend more money elsewhere. The Keynesian Cross “proves” that aggregate expenditures and GDP are identities, so it really doesn’t matter if money is spent on capital goods or consumer goods since the results are the same.

Then what causes the economic downturn? Krugman has an easy answer:

A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time.

In other words, large-scale mal-investments really don’t matter; instead, it is the panicked consumer that decides in the face of economic uncertainty that saving money might be a good thing. Indeed, as Robert Murphy notes, US savings rates quadrupled from late 2007 to mid-2009 (from about 2 percent to 8 percent) so that would seem to verify Krugman’s causality. But it doesn’t.

To counter Krugman’s thesis, I go back to the Austrians but not Rothbard. Instead, I turn to Carl Menger, the “founder” of the Austrian school who begins the opening chapter in his groundbreaking Principles of Economics with:

All things are subject to the law of cause and effect. This great principle knows no exception, and we would search in vain in the realm of experience for an example to the contrary.

While these words hardly seem to refute anything, let alone Krugman’s stated cause of economic downturns, look again. Austrian analysis is monocausal, that is, there is a cause and an effect. Krugman’s theory (I assume he believes his theory is “settled science”) brings up an interesting question: Why do consumers suddenly cut back on their spending begin saving? Krugman never says.

It seems that one obvious reason is that consumers are unnerved about the economic downturn, but if Krugman’s statements about the breakdown of the boom are correct, then consumers would have no logical reason to be nervous. Perhaps Krugman might claim that those dastardly Austrians have fooled everyone into thinking that credit-fueled booms are unsustainable, so when someone goes out of business or some other economic indicator points downward, people panic and the Austrians then goad them into saving more money.

But why don’t consumers start spending again as soon as someone in Washington gives the equivalent of the “all clear” signal? After all, the Keynesian paradigm dominates in politics, the media, and in higher education. The notion of Austrians playing the role of Emmanuel Goldstein is a bit far-fetched, given the Austrians don’t have much of a media or political platform. How Austrians can scare an entire population into sabotaging the economy by increasing their savings lacks the authenticity of Mengerian causality.

When they look at the increase in savings, Austrians ask the following: Why the sudden increase in savings? In fact, if we look at US personal savings rates for the past sixty years, we see that savings rates do increase at some point in most recessions, but they increase during the recoveries, too, so there is no way one can draw a clear causal inference that moves from the growth in personal savings to a recession.


The monocausal view would lead us elsewhere. In Krugman’s world, people irrationally start saving, send the economy spiraling downward, and then it takes government—led by brilliant technocrats like Krugman—to spend and inflate the economy back into prosperity. To the Austrians, the notion of people suddenly stampeding to save their money for no visible reason in nonsensical. Furthermore, contra Krugman, saving money is not an irrational response to a perceived change in the economy. People don’t save in a vacuum; they save in order to be able to spend in the future, either for a major purchase or for times when their incomes are less than they are at present. In short, the evidence shows that people quickly change their saving habits in response to a crisis, as opposed to an increase in savings creating the crisis.

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