Yes, Paul Krugman, Booms Are Unsustainable

Krugman claims that even large-scale mal-investments really should have no overall effect, writing:

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.

Elsewhere, he states of the Austrian theory:

[T]his story bears little resemblance to what actually happens in a recession, when every industry—not just the investment sector—normally contracts.

His statements show ignorance in two areas: capital theory and the actual events of the business cycle. Rothbard corrects Krugman’s errors, first by pointing out that the crisis is characterized by what Rothbard calls a “cluster of (entrepreneurial) errors,” and then by noting that the downturns do not hit all sectors equally:

It is the well-known fact that capital-goods industries fluctuate more widely than do the consumer-goods industries. The capital-goods industries—especially the industries supplying raw materials, construction, and equipment to other industries—expand much further in the boom, and are hit far more severely in the depression.

This is important, as the crisis does not occur because people stop spending and then all business sectors shrink accordingly. The capital goods and related industries are likely to have the greatest number of mal-investments, so it stands to reason that they would be hit hardest in the crisis.

Krugman does make an interesting point: If the problem is just mal-invested capital, why can’t workers make the quick transition back to employment in sectors not hit as hard? In fact, that often was what happened in previous business cycles. Thomas Woods writes of the 1920–21 recession that it was severe—and short. Writes Woods:

The economic situation in 1920 was grim. By that year unemployment had jumped from 4 percent to nearly 12 percent, and GNP declined 17 percent. No wonder, then, that Secretary of Commerce Herbert Hoover—falsely characterized as a supporter of laissez-faire economics—urged President Harding to consider an array of interventions to turn the economy around. Hoover was ignored.

Instead of "fiscal stimulus," Harding cut the government's budget nearly in half between 1920 and 1922. The rest of Harding's approach was equally laissez-faire. Tax rates were slashed for all income groups. The national debt was reduced by one-third.

The Federal Reserve's activity, moreover, was hardly noticeable. As one economic historian puts it, "Despite the severity of the contraction, the Fed did not move to use its powers to turn the money supply around and fight the contraction."2 By the late summer of 1921, signs of recovery were already visible. The following year, unemployment was back down to 6.7 percent and it was only 2.4 percent by 1923.

In other words—contra Krugman—there was no intervention, no money printing, no jobs programs, nothing that Krugman claims are vital to bring economic recovery. If one realizes that this downturn came in the aftermath of World War I when the war-spending boom quickly contracted and accompanying the return of millions of soldiers was the Spanish Flu pandemic which killed 500,000 Americans (when the US population was 104 million, less than a third of the population today). Yet, the economy quickly recovered when the economy moved out of inflation-driven war goods production back into production commensurate with postwar needs.

Austrians do not question booms because they don’t like prosperity or because they have character defects. Rather, Austrians understand that booms involve lines of investment into areas of production that cannot be sustained, even when government throws even more money at them. What Krugman calls “perfectly good productive capacity” actually is mal-invested capital that is idle for a reason.

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