paul krugman and the austrian business cycle

A lot of people read Paul Krugman's op-ed's each week in the New York Times. He is perhaps the most read economist in the United States. In fact, when it comes to his research areas, such as location theory and economic geography, he was able to win a Nobel Prize in economics. However, the it is a complete fallacy to equate this award with Krugman's ability to make macroeconomic predictions based on Keynesian theories. Krugman won the 2008 Nobel Prize due to of his research relating to economies of scale and and their effects on urbanization in developed nations. This empirical research and the associated theories have almost nothing to do with the political rhetoric that he spews in his column on a weekly basis.

For instance in his column this week entitled Reagan Did It, Krugman postulates that Reagan's deregulation of the the banking and financial markets caused Americans to abandon fiscal thrift and take on too much debt, which caused the current economic downturn. Here a a few illustrative quotes from the article:

The increase in public debt was, however, dwarfed by the rise in private debt, made possible by financial deregulation. The change in America’s financial rules was Reagan’s biggest legacy. And it’s the gift that keeps on taking . . . It was only after the Reagan deregulation that thrift gradually disappeared from the American way of life, culminating in the near-zero savings rate that prevailed on the eve of the great crisis . . . These defaults in turn wreaked havoc with a financial system that — also mainly thanks to Reagan-era deregulation — took on too much risk with too little capital.

First, I am not even going to address the individual freedom and personal liberty issue that government should not be in the business of telling its citizens how much debt they are allowed to take on. According to Krugman, an all-knowing financial regulator/bureaucrat knows how much debt an individual should be allowed to accumulate, rather than allowing the market let a variety of creditors determine the proper amount for each individual on a person-by-person basis based on a multitude of risk related factors. Instead I want to address why Krugman is completely off-point when he claims the "deregulation" and the associated increase in private debt (and by the way he does not point out any specific provisions of the Garn-St. Germain Depository Institutions Act that would provide incentives for individuals to take on too much debt) caused the recession we face today. In fact, Krugman does little more in the article than assert that a lack of governmental regulation of the credit markets was the reason that consumers took on large amounts of debt.

Krugman is correct when he points out that excessive private debt had a role to play in the economic downturn. However, the reason for this increase in American indebtedness cannot be attributed to the abstract theory of "Reagan Deregulation." Perhaps the reason that Krugman attributes this increase in debt to deregulation is because he does not accept the Austrian theory of the business cycle. Krugman has received much acclaim for this 1998 article entitled The Hangover Theory, in which he dismissed the Austrian business cycle theory. However, as many commentators have been quick to point out, Krugman at best misapplied the theory and at worst he deliberately misrepresented it in order to make a political point. For instance, he claimed that the theory can be described in the following way:

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. . . 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 . . . Here's the problem . . . [a]s 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?

However, Krugman's characterization oversimplifies the theory. He claims that theory postulates that for "whatever the reason" for the malinvestment, there must be an economic downturn proportional to that malinvestment. However, the theory states that the control of the monetary supply by a central bank, which can artificially lower interest rates by directly injecting newly created money directly into the credit markets, causes unsustainable booms and busts because investors, who under normal market conditions would more highly value present capital over future investments with too much risk to justify the necessary debt are induced to malinvest because of the artificially lower interest rate. Krugman ignores the central bank's critical role in causing the boom by distorting the risk analysis and eliminating an interest rate that accurately reflects market conditions. Additionally, the theory does not necessarily require high unemployment during the "bust" part of the cycle. Instead, the theory claims that unemployment during the recession results from rigidity in real wages and that if wages were allowed to decrease, a increase in unemployment might not necessarily occur during the liquidation of the bad investments.

The Austrian theory very accurately describes the causes of the current economic downturn and even the traditionally leery media has begun to accept the fed's role in the recession. By keeping interest rates lower than they would have been absent monetary expansion that exceeded the accompanying increase in economic output, the fed created the conditions necessary for the housing bubble and other malinvestments of capital. If interest rates had been determined by market conditions, many of the homeowners who are currently defaulting would not have been approved for such large loans, and financial institutions would not have taken on such a large share of high risk sub-prime and option-ARM loans. Krugman would have you believe that greedy businessmen were trying to game the system absent proper regulation and things like mortgage backed securities were a way they could quickly profit from this excessive risk. Now I am not saying that the fact that these loans were securitized and spread to all sectors of the financial industry were not also major contributing factors to harshness of the downturn, by they would not have been created in the first place (at least not on such a large scale) but for the fed's loose money policies throughout the first half of the decade.