Arnold Kling  

A Simple Reply to Krugman on Austrian Economics

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My Letter to Wall Street Journ... Unable to Simplify...

Paul Krugman writes,


why isn't there similar unemployment during the boom, as workers are transferred into investment goods production?

He says he has asked this before, and he has. I have answered it before, and he has never responded.

The answer is that booms are slow and crashes are sudden. A small percentage of the labor force transfers each year during a boom. When a crash hits, a very large percentage of the labor force needs to find new work.

This leads to a new question. Why do booms develop more slowly and persist longer than crashes? I suspect that the answer is analogous to what we used to call "the Peso problem." As I recall, in the Peso problem, you observe persistently above-normal returns from holding Peso-denominated securities. That is because market participants are divided between Peso-believers and Peso-doubters. The Peso-doubters are effectively buying insurance from the Peso-believers--hence the above-normal returns. At some point, however, the insurance policy may pay off--the Peso may crash. The crash will be sudden.

During the housing boom, the housing doubters suffered below-normal returns, while the housing believers earned above-normal returns. Housing doubters could by insurance in the form of credit default swaps from folks like AIG. So, we had a relatively long, persistent boom in housing and mortgage finance. Then a a sudden crash.

I admit that in my own mind I combine a Minsky model of financial cycles (not his macro, which I do not care for) with an Austrian model of Recalculation, meaning that unemployment results when markets need to make a large, sudden reallocation of labor.


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COMMENTS (43 to date)
wlu2009 writes:

It doesn't seem that his addresses fully why the crash is sudden. Why was the build up in home prices slow, and the decline quick? Why don't we see quickly increasing prices and slowly decreasing prices?

Kevin writes:

This is so easy to understand that it's difficult to believe that Krugman actually doesn't get it. Everyone knows liquidity gets strained when an unusually high amount of a thing comes to the market on the bid or offer. Couple that with stickiness (from various sources, not least price controls and subsidies), and you get a market that doesn't clear, i.e. unemployment. That said, it's not difficult to believe his fans don't get it.

Your Peso example for the speed of the crash is excellent. I personally prefer the adage about option writing - you go out of business fast buying options and slow writing them. Booms are fueled by put writers.

Gu Si Fang writes:

You are right. Krugman seems to think that the boom and the bust should be symmetric. He mentions austrians' reluctance to use models. In a macro mathematical model, there is no direction of causality. A growing bubble and a credit crunch are the same thing in reverse. But in fact the boom and the bust should not be symmetric because their causes are not at all comparable.

Here is a comment just posted on Tyler Cowen's blog :

During the boom, resources are invested at the margin into credit-financed activities and drawn away from others. The guy who is in real estate ends up with a profit slightly higher than expected. The guy who is in the other sector makes a lower profit than expected. Nothing really draws their attention. Their plans seem to be running smoothly, with some marginal adjustments. Low uncertainty is good for the labor market. A keynesian would describe this situation as one of high confidence, low preference for liquidity. A post-keynesian would recite the Minsky story. All this is consistent.

[Comment elided. The remainder may be found at
http://www.marginalrevolution.com/marginalrevolution/2010/04/krugman-on-austrian-business-cycle-theory.html#c6a00d8341c66b253ef01347fbb6420970c
Reposting lenghty comments that you have already posted elsewhere is not allowed on EconLog. In the future, please summarize your comment, select a relevant paragraph from it and provide a link, or write a new comment unique to EconLog.--Econlib Ed.]

fundamentalist writes:

Krugman is correct if his baby-sitting co-op model of macro holds. He thinks it does, so anything that doesn't fit that model is wrong. Krugman will never accept any explanation that doesn't fit his model, which is why he thinks no one has ever answered him.

Another reason for the slow burn boom and sudden bust is that the recovery starts with increased savings. And people are leary of another bust, so they are more careful. The boom picks up speed as businesses slowly borrow more to expand. Both banks and businesses are cautious. At the peak of the boom, both banks and businesses have abandoned caution. So psychological factors make the boom develop slowly.

The bust is sudden for similar psychological reasons. People are ten times more afraid of losing money than they desire to make money. So the first major default on a loan during the boom sends shock waves through the economy and everyone gets scared at once.

The same thing happens to the stock market. After a bust, people test the "waters." They put a little money in and wait. If no disaster happened, they put in a little more. Caution makes us take risks slowly and only after little successes. But when bad news hits, everyone hits the exits at the same time.

Boonton writes:

This would make sense if all the unemployment of the crash was related to the boom. If, say, housing and finance had slowly grown to be 15% of all employment and then the crash! Now 2/3 of housing and finance people are out of work resulting in 10% unemployment.

But tht's not what happened. Yes housing and finance took a big hit but most of the job loss happened outside the boom. The problem with the Austrian POV IMO is that it assumes booms can be irrational but corrections cannot. If corrections can become too irrational the recession ceases to be simply about 'recalculation' and starts to become a destroyer of human and physical capital. The Keynesian idea of short term stimulus to keep the correction from going too far seems to be consistent with the Austrian ideas as they have been presented here.

eccdogg writes:

I kind of think of the bust being quick, is somehow based on the bigger fool theory of prices.

Market participants benchmark prices to recent prices not to fundamentals. No one really knows what the fundamentals are. They just know that security x has recently sold for price y and so if I can buy if for y-1 and sell it later for y+1 I can make money.

Everyone in the market knows there is nothing special about the price y, it could be between .5*y and 1.5*y given different assumptions.

So when it becomes clear that the price is moving there is a run for the exits because no one is confident in the buy and hold strategy. Eventually you reach a floor where buy and hold guys come in (think Buffet), but they are only willing to do so at much lower prices than what prevailed before.

Lord writes:

This still doesn't explain the asymmetry and the asymmetry is key to the problem. Why doesn't insurance go the other way during downturns? What you need to explain is how there can be higher profits that lead to a boom, but losses leading to a bust. The reason must be the growth of business with higher short term profits during booms whose collapse leads to shifts to less profitable business during busts. The less profitable business simply can't expand enough to make up for the loss in higher profit business. If profits were equivalent in these other businesses, there would be no collapse, only a shift towards them, and if they were more profitable the shift would be seamless. It is the shift towards less profitable business that causes the downturn.

bjk writes:

In a rising market, the sellers are cashing out and enjoying profits. In a declining market, the sellers are taking losses. That's why markets fall faster than they rise.

Lee Kelly writes:

Another explanation is that an economies' propensity to create a speculative bubble increases as the money supply expands relative to money demand.

The excess supply of money increases spending on capital goods without a decline in spending on consumer goods. The seemingly high returns on investments like housing increase the propensity of a speculative bubble emerging, i.e. the speculative bubble piggybacks on the monetary distortion. However, since the demand for consumer goods has not actually declined, the price level must eventually rise and the high returns will prove to have been illusory. A noise was introduced into the price system, and so its signals were creating systemic distortions.

However, in my opinion, Krugman has a point: why is the bust so sudden? I think it's because the recalculation (as Kling calls it) is usually complicated by monetary disequilibrium--in this case, an excess demand for money.

Anything that lowers the relative risk of owning money will increase the chances of a sharp increase in money demand, because owning money is perceived as a safe alternative to other assets. Government monopolies socialise the risk of owning money, so the risk of owning money does not rise and fall proportionally to the risk of owning other assets. Thus, present government policies intensify swings in the demand for money during times of panic and uncertainty. This goes for bank reserves too--why should banks have access to a risk free asset (and recently interest bearing) asset?

A more volatile demand for money requires more timely and accurate changes in the supply of money. However, central banking institutions popular with governments around the world are limited to extremely crude means of estimating the supply and demand for money. Even if central banks were capable of satisfying changes in money demand in a timely manner, none (so far as I am aware) make it their goal. In fact, most central banks ostensibly pursue modest inflation targets--a goal that can only be achieved by purposefully engineering monetary disequilibrium.

Put these two things together and you have a situation where busts are likely to cause a big excess demand for money, thus magnifying the recalculation problems and causing a rapid decline in economy activity. What follows is Keynes's paradox of thrift (which is really a paradox fo saving money (or, for ban ks, reserves) when a monopolist of the money supply doesn't satisfy changes in demand.

Boonton writes:

http://feedproxy.google.com/~r/BradDelongsSemi-dailyJournal/~3/3FedDBLjfPw/mark-thoma-sends-us-to-julie-hotchkiss-of-the-atlanta-fed-on-layoff-hiring-and-unemployment-rates.html

I'm not sure this graph helps us a lot with the theory but it appears the current recession's unemployment was driven by a collapse in the hiring rate, not a sudden spike in the layoff rate.

Wouldn't recalculation be the opposite? Wouldn't the boom areas suddenly see massive layoffs as panic sets in while the non-boom sectors of the economy continue as they were before?

Boonton writes:

Lee,

So during the boom we basically had too much money. But during the bust we now have, what? The right amount of money, too much or too little?

Basically right now we are sitting on top of a massive amount of stimulus. A little bit of that was the actual stimulus bill Obama got passed with a lot of hyperventilating by all sides, a bit more is the 'automatic stabalizers' that swing fiscal policy during a recession and below the waterline is the massive stimulus from the Fed in pushing rates down to zero and then engaging in 'quantitative easing' by purchasing non-traditional assets in the marketplace. Despite all this we still had a massive decline in output and spike in unemployment. Anyone who says the Fed shouldn't have done these things, should have left rates alone or even raised them seems to be advocating a policy of throwing gasoline on a fire.

Is the Austrian view that is what is needed, a super-recession to 'liquidate the excesses' all the faster so we can return to 'normal' sooner? Say 6 months of 40% unemployment rather than two years of 10%? If not then at the end of the day I'm not seeing a big difference between the schools....except maybe a slight preference for monetary based stimulus during deep recessions (or 'recalculations')....which makes me wonder if this isn't just Milton Friedman's monetarism cross dressing so it fits in at the Ayn Rand convention!

liberty writes:

"Is the Austrian view that is what is needed, a super-recession to 'liquidate the excesses' all the faster so we can return to 'normal' sooner? Say 6 months of 40% unemployment rather than two years of 10%? If not then at the end of the day I'm not seeing a big difference between the schools...."

Yes - except that it would not likely be 40% -- and it could be much worse than 2 years at 10% with massive government interventions.

Contrast the 1920-21 depression to the 1929-1946 depression. The two booms and crashes were similar, the loss of GDP, the hit to the stock market, and the initial rise in unemployment were all similar.

Government did absolutely nothing in 1920 and allowed a "super-recession" - or a "correction" as one might describe it, to occur. Unemployment rose quite high -- I think it hit 20% at one point, and it remained above 12% for about 6 months I think -- but by 1922 it was back to down to 6% and then 4%. There was no debt, the depression did not drag on, and the 1920s was booming, with a lot of real productivity gains.

As you are well aware the 1929 depression was not over nearly as fast -- and unemployment went just as high or higher. The depression lasted well over a decade, and did not end until the price controls were repealed and war reconstruction employed people to recreate output that was lost during massive destruction.

Lord writes:

You said once, the difference between boom and bust is during the boom resources know where to go while during the bust they do not. The reason for this is there is no more profitable industry to go into. The growth of the capital goods industry and its higher profits are the locomotive force of the economy; the rest is boxcars, deadweight being hauled by them. When the engine fails, there are no other engines to take their place, only inertia keeping them moving and friction slowing them down. It is only creation of a new engine that can pull the economy forward. Simply transferring resources into deadweight doesn't do it.

jean writes:

There is a peso problem because the peso is pegged to the dollar.
But what is the peg here? The peg was quite clear at the time of the Gold Standard but not now.

Ritwik writes:

Arnold,

Booms and busts are definitely asymmetric. Labour is surely heterogeneous. Asymmetricity + hetrogeneous labour can surely explain unemployment.

Your recalculation story is essentially a story of heterogeneous labour (organizational capital etc.)It is a very intuitively satisfying theory of unemployment (thought not necessarily the best one). It is a theory quite accommodating of income effects.

The ABC theory is mainly a theory of heterogeneous capital and substitution effects. It is a lot less satisfying and much easier to rebut than the recalculation theory. The positive correlation of investment and consumption is the simplest and strongest such rebuttal.

Boonton writes:

liberty

As you are well aware the 1929 depression was not over nearly as fast -- and unemployment went just as high or higher. The depression lasted well over a decade, and did not end until the price controls were repealed and war reconstruction employed people to recreate output that was lost during massive destruction.

1. When talking about the Great Depression the 'over the decade' line is almost always used to obscure the fact that the economy did recover but when back into recession in 1937 when attempts were made to return to budget orthodoxy! And price controls were not repealed until AFTER WWII ended and 'war reconstruction' didn't employ the unemployed, it was 'war making'. The US itself suffered very little direct destruction from WWII aside from the members of its labor force killed and injured in the war. You're basically saying massive Keynesian fiscal stimulus solved the problem. So what's the problem? Presumably if we didn't have Hitler and Tojo causing us problems we could have done a massive highway, infrastructure program and recovered in the same way.

2. The response of the gov't to the Great Depression is not anywhere near a page from Keynesian and Monetarist playbooks. FDR did some things right like looser monetary policy (for silly reasons, setting the price of gold each morning with the help of a crackpot farm economist) and some things that were just out there like trying to cartelize major sectors of the economy. Just because FDR is liked by Keynesian economists doesn't mean FDR would be followed during a new Depression.

3. You mistake the 'below the waterline' aspect of stimulus, namely monetary stimulus. From wikipedia:

The United States had adopted the Federal Reserve System in 1913, and the institution was still new. Milton Friedman and Anna Schwartz, in A Monetary History of the United States, identify mistakes in Federal Reserve policy as a key factor in the crisis. At the end of the war the Federal Reserve Bank of New York began raising interest rates sharply. In December 1919 the rate was raised to 4.75% from 4%. A month later it was raised to 6% and in June 1920 it was raised to 7% (the highest interest rates of any period except the 1970s and early 1980s). The high rates sharply reduced the amount of bank lending in the country, both to other banks and to consumers and businesses.[2][8]
Rates were sharply reduced in the latter half of 1921. The New York Federal Reserve reduced rates in successive half-point moves over the July- November period from the 7% high to 4.5% on November 3 1921. The depression ended.


Nearly doubling rates and then halving them in the space of two years is hardly government doing nothing. Yet wikipedia tells us the Austrians think the gov't didn't do anything: "Historian Thomas Woods argues that President Harding's laissez-faire economic policies during the 1920/21 recession...."

Now if Harding had, say, doubled gov't spending and then cut it in half there's no way he'd be described as 'laissez-faire'. If he doubled taxes then cut them in half, the same would apply. Yet here the Fed doubling rates and slashing them is ignored! This is why people both love and hate the idea of the Fed. The strings they pull are massive but most of the time people aren't looking behind the curtain....instead they are reading the newspaper which is talking about the President 'talking down the dollar' or asking a auto executive not to slash wages.

Now there was a mini-recession after WWII when a lot of GI's returned home and unemployment briefly spiked as they looked for work. I think its quite likely the 1919 recession was similiar but coupled with a stupid policy of 'unstimulating' the economy with the doubling of rates. It may be that those are examples of 'recalculation recessions'. What's interesting, though, is that stimulus and not anti-stimulus would seem to be the correct policies.

Again I'll ask what do the Austrians think we should have done in regards to stimulus (and please answer keeping in mind that stimulus here is something like 80% Fed and 'automatic' policies, 20% formal 'stimulus bills')? Raising rates to 'liquidate the bad' seems to be implied but they don't say it explicitly. Yet the example of 1919 would seem to indicate that such a policy is counter productive. We suffered more in the post-WWI 'adjustment' than the post-WWII even though WWII was much larger in terms of changed resource allocation in the economy.

Allan Walstad writes:

When money is pumped into the economy through the banking system, the people who get the money first can pursue capital projects by hiring workers away from other employment. Nobody has to get put out of work to start with. People who are already working can simply pick up on new opportunities. Later, when unsustainable projects fail, people do lose jobs and have to look and wait until things restructure and other employment comes along. Yes, in both cases labor is being redistributed, but the mechanism and timing are essentially different. In the boom, the new opportunities come first. In the bust, you have to wait for the new opportunities. So the boom and bust are different for reasons that have nothing necessarily to do with how slow or sudden they are.

That's the way it seems to me. If wrong, I'm interested in the explanation.

Lord writes:

Under Austrianism, there is no need for recalculation; everyone knows more consumption goods will be needed, so there shouldn't be any waiting for opportunities to come along. Presumably the only reason they don't appear is too much was lost in the collapse to invest in the consumption boom. But the whole point of investment is borrowing to invest in the future, not obsess about sunk costs. What prevents borrowing under a fiat currency? Collateral? Willingness? Fear? Austrians would say it requires real resources, but those are what are becoming increasing unemployed every day during the bust. They really can't explain the bust.

Trevor F writes:

Didn't we just go through this in real life? I recommend the intro to George Soros' Financial Alchemy as the best explanation of why credit-fueled booms are asymmetric.

Credit gets written slowly, because you evaluate your buyers as they need credit, not everyone who will need credit over the course of the boom.

After the peak, you end up with solvency and liquidity issues, as credit doesn't get repaid but creditors have liabilities to repay. You get a "bank run" equivalent, meaning everyone needs to race everyone else to liquidate to pay off debt before prices drop. Of course, this causes prices to drop rapidly.

Doc Merlin writes:

@wlu2009
The complexity issue answers that. Its also a post today on this blog. The more complex systems are the more rigid they become. So a drop is a collapse.

Another possibility is that the transaction costs to short sell are way higher than the costs to buy long.

Boonton writes:

When money is pumped into the economy through the banking system, the people who get the money first can pursue capital projects by hiring workers away from other employment. Nobody has to get put out of work to start with. People who are already working can simply pick up on new opportunities. Later, when unsustainable projects fail, people do lose jobs and have to look and wait until things restructure and other employment comes along.

Let's pretend the way the Fed pumps money into the economy is loading it into a bag and firing it out a cannon. The bag will land within a mile or so of the NY Fed in some random direction. What would happen? Basically the value of property within a mile of the Fed would rise in porportion to the odds of the bags of money landing on it. In theory the people who 'get the money first' should have no advantage. To be able to be in a position to 'get the money first' you should have to pay a price to aquire said spot in line with the value of that advantage.

Two this model seems to be one where the 'regular economy' creates and destroys a set number of jobs in each time period since we are going to assume full employment for now. Say the cannon starts firing some cheap money into the economy and those within a mile of the NY Fed start buying capital goods with their newfound money.

1. Employment in capital producing goods rises. Check

2. Everywhere the normal flow of workers leaving and taking jobs is disrupted. Workers leave assorted jobs but they don't get rehired, the capital sector sucks up all the free workers.

3. Wages would have to increase in both sectors since the regular economy lacks unemployed workers to hire from and the capital sector is seeking more and more workers. Higher wages mean higher income which means increased demand for both consumer goods and capital goods to make them. Since the economy was at full employment (by assumption) before this began, the result must be either inflation to level off demand or shortages if for some reason prices are not able to rise (either from social custom or gov't fiat).

From this little story a crash is hardly obvious. The capital projects from the 'free money' are neither unsustainable nor irrational. Inflation, not deflation levels off the growth rate and those who invested in producing capital goods are well rewarded.

The crash is only obvious if the investment in capital goods is irrational. If a bag of free money landed on my doorstep tomorrow, I might hit the Mall. I might buy a business. I hope I wouldn't buy an insane business. I hope I wouldn't lend a janitor who makes $25K a year $500,000 to buy a house that sold last year for $300,000! I hope I wouldn't give a company $5B to, say, deliever groceries over the internet when all business plans project the company will take 250 years to break even. The Boom requires irrationality, not simply 'easy money'. If irrationality can cause an economy to become unsustainable then there's no logical reason why the reverse couldn't happen, the shock of the crash couldn't cause the economy to become too skitish, too terrified of its own shadow and drive business down too much. Hence the argument for stimulus.

Krugman is correct IMO, Austians seem to want it both ways. Going up they would allow the economy to deviate from full employment, efficient markets, rationality. On the way down, though, they want to smoke up the Say's Law crack to the hilt.

Tom writes:

I think Bob Murphy's article is a good reply to Krugman's objection.

Lord writes:

In other words, why do capital good booms lead to busts, but consumptions good booms do not.

Boonton writes:

Doc
The complexity issue answers that. Its also a post today on this blog. The more complex systems are the more rigid they become. So a drop is a collapse.

Seems like a cop out to me. My computer is more complex than my calculator yet that complexity gives my computer the ability to do much more than my calculator could ever do. The calculator is the thing that is rigid, its only good for doing quick math when I'm not in Excel. Rigidity is a feature of simple systems, not complicated ones.

The classic 'calculation problem' that is used to object to socialism is based on complexity, not simplicity. The 'socialist planner' fails not because he has a complex system but a simplistic one. As many pages are are taken up by his '5 year plan' the fact remains his system is a lot more simple than the trillions of data points of information processed by the decentralized capitalist system. His system collapses because it lacks the complexity to adjust itself to changing circumstances.

Allan Walstad writes:

Lord writes:
"In other words, why do capital good booms lead to busts, but consumptions good booms do not."

That's easy. Capital projects take investment expenditures now in the hope of profiting from returns in the future. If costs go up in the meantime, or if the projected returns do not materialize, the projects fail. The resources turn out to have been misallocated. If an unusually large number of capital projects are failing, it means an unusually large amount of resources have been misallocated, decreasing productivity and causing disruption. Consumption goods generally are purchased now to be enjoyed starting now, not in the hopes of selling later and making a profit. The cases are fundamentally different.

Housing is an interesting hybrid. For families, buying a home is an investment in the hopes of long-term payoff in quality of life as well as equity. (For some folks, of course, houses are a speculative investment with profit in mind.) Easy money from the Fed made homes look affordable that weren't. Increased demand drove up prices and made homes look like a winning investment. The bubble burst and people ended up owing more than the homes were worth, and more than they could pay when the teaser rates expired.


Boonton: "The crash is only obvious if the investment in capital goods is irrational."

Apply marginal thinking. At any given time there is a great range of both possible and actual capital projects, from those that will be big winners to those that will be massive failures. Easy money makes all projects look better. At the margin, it encourages more projects that will fail, and it allows weaker projects to persist longer before they fail, thereby wasting more resources. The key here is that interest rates and market prices convey information, and if Fed tinkering with money and interest rates distorts that information, there will be more bad investment moves. It's not about people becoming "irrational" when somebody drops a sack of greenbacks on their doorstep.

Max writes:

Are crisis and boom really that different in velocity? I doubt it, it is just that a boom is more obvious, because it outpaces the bust for a long time. I the beginning we have a pure boom, when businesses make decisions and they seem right. Then somewhere along the way the start investing into suboptimal projects, but it is not visible at first sight. This is the beginning of the crisis, but it is not to be seen because the boom is still driving the business cycle and the potential crysis is too small. Then comes the point where the accumulated mistakes overtake the booming industry and a sudden realization takes place.

So, in my view, both, booms and busts, are equal in their velocity, they are just not both visible from the start.

liberty writes:

Boonton-

"1. When talking about the Great Depression the 'over the decade' line is almost always used to obscure the fact that the economy did recover but when back into recession in 1937"

If by recover you mean getting unemployment back down to only 15% ! It was nothing like the actual recovery of 1921-1922.

"And price controls were not repealed until AFTER WWII ended and 'war reconstruction' didn't employ the unemployed, it was 'war making'."

Right - and recovery did not come until 1946 -- and yes, the war temporarily employed or killed hundreds of thousands of young American men; but this is not recovery. I can create a nice plan of killing the millions of unemployed we have today, but I don't think (even though it would eliminate official unemployment) that it would actually constitute recovery.

But after the repeal of the price controls, and the end of the "stimulus" of the new deal, real recovery did come - and reconstruction was part of that--we'd destroyed a lot of the economy over the past decade, and rebuilding and bringing back the soldiers into civilian life, was part of what got the economy going again, finally.

"Presumably if we didn't have Hitler and Tojo causing us problems we could have done a massive highway, infrastructure program and recovered in the same way."

No, the point is that rebuilding after destruction is NOT stimulus - it is recreating the output you've just destroyed -- getting back to square one. If we have a little town with two butchers and two bakers, and there are ten people total - two of whom are unemployed - the way to increase the town's standard of living is not to bomb the bakers and then hire the unemployed to rebuild it. Yes, they will be employed, but everyone in town will be worse off because there won't be any bread. This kind of "stimulus" is an illusion--whether it is war or bad government policy (digging holes and filling them) that is employing people in this way.


"2. The response of the gov't to the Great Depression is not anywhere near a page from Keynesian and Monetarist playbooks. FDR did some things right like looser monetary policy (for silly reasons, setting the price of gold each morning with the help of a crackpot farm economist) and some things that were just out there like trying to cartelize major sectors of the economy. Just because FDR is liked by Keynesian economists doesn't mean FDR would be followed during a new Depression."

Fair enough - except that Keynes and many of his later followers did believe in cartelization and keeping prices and wages high. FDR had policy advisors of the time that defended these policies along Keynesian lines, and Keynes had praised Hoover's wage-fixing policies.

http://www.themoneyillusion.com/?p=48

"3. You mistake the 'below the waterline' aspect of stimulus, namely monetary stimulus."

I have not studied the monetary interventions for either depression closely, as I am not a monetary economist. My criticism is of the fiscal stimulus and interventions in pricing and output, bailouts or subsidies etc that interfere with the correction and recovery; along with the creation of the bubbles that burst in the first place -- I am honestly not sure what the best monetary response is except that at some point the inflation must stop.

My argument was that the 1920-1921 depression was easier to recover from being there were no (other) interventions, aside from whatever the Fed did to recover from its own bubble/burst creation, whereas in 1929 there were many (other) interventions that dragged the depression out for a decade and a half.

Now, you can argue that none of the interventions were important except the monetary ones -- but I doubt this very much.

Boonton writes:

Right - and recovery did not come until 1946 -- and yes, the war temporarily employed or killed hundreds of thousands of young American men; but this is not recovery. I can create a nice plan of killing the millions of unemployed we have today, but I don't think (even though it would eliminate official unemployment) that it would actually constitute recovery.

Unemployment is measured by those in the domestic market looking for work. The war didn't generate recovery by putting everyone in the army. Those who weren't drafted could have still, in theory, found difficulty finding work at home and remained unemployed. They didn't, the economy boomed and even with large numbers of women entering the workforce there were plenty of jobs to be had.

But after the repeal of the price controls, and the end of the "stimulus" of the new deal, real recovery did come - and reconstruction was part of that--we'd destroyed a lot of the economy over the past decade, and rebuilding and bringing back the soldiers into civilian life, was part of what got the economy going again, finally.

After the war ended price controls remained in place for several years, they were even an issue in the Eisenhower race. The major elements of the New Deal remained in place and the economy had gone through massive distortions due to both direct government command of major pieces of the economy as well as the tooling many private companies like Ford did to supply the gov't's need for supplies rather than consumer goods.

Yet the post-WWII recession was so trivial, so minor that its thought of more as a little blip as GI's spent a few months looking for new jobs as they came home. How could this be when WWI, which for the US was a much smaller event for the economy, still managed to generate a nasty little recession in 1919-21?

By your theory 1919 should have been the trivial recession that didn't even make it since the gov't didn't make such a dramatic drain on the economy and moved quickly out of the way when the war was over. In contrast WWII was the opposite. The gov't's impact on the economy was massive, it was slow to repeal many of the direct wartime economic measures and it didn't repeal the major New Deal provisions from the previous decade. Where was the massive post WWII correction from the massive neglect of following your policy advice?

No, the point is that rebuilding after destruction is NOT stimulus - it is recreating the output you've just destroyed -- getting back to square one. If we have a little town with two butchers and two bakers, and there are ten people total - two of whom are unemployed - the way to increase the town's standard of living is not to bomb the bakers and then hire the unemployed to rebuild it.

Let me say this again, there was no 'reconstruction' in the US after WWII. Aside from Pearl Harbor, there was maybe one or two bombs that fell on the US. This is a factor in looking at Europe and Japan but not the US.

Fair enough - except that Keynes and many of his later followers did believe in cartelization and keeping prices and wages high. FDR had policy advisors of the time that defended these policies along Keynesian lines, and Keynes had praised Hoover's wage-fixing policies.

And FDR ran on balancing the budget, didn't make an effort to undo the protectionism passed in Hoover's time and didn't opt to support the European central banks in an effort to stabalize their currencies. Politicians are not theorists. I think its pretty fair to say that in the decades since stimulus (both monetary and fiscal) have entered the toolbox of recommended policies by most economists. 'Cartelization' has not. Its fair to point out that its easy to forget that FDR did a lot of putzing around on various ideas. At the same time, with so many different ideas being played with its not quite fair to say the length of the depression disproved the effectiveness of stimulus.

This is nothing new historically. Lincoln, for example, is seen today as a hero for civil rights because he 'freed the slaves'. At the time, though, he was hardly an abolitionist. For decades he was willing to compromise with slavery, willing to go on record against equality, so much so that even the abolitionists of his day didn't really trust him but felt he was the lessor of two evils.

I have not studied the monetary interventions for either depression closely, as I am not a monetary economist.... My argument was that the 1920-1921 depression was easier to recover from being there were no (other) interventions, aside from whatever the Fed did to recover from its own bubble/burst creation, whereas in 1929 there were many (other) interventions that dragged the depression out for a decade and a half.

First, how can you say this? This is like a doctor saying he has studied vitamins quite a bit but has never bothered to read up on anything related to blood so he has no opinion on high blood pressure, hearts or circulation....but he can note that your Aunt Augie who just passed from a heart attack had stopped drinking her daily glass of OJ a month before so maybe that's the culprit!

Second, you got the Fed's intervention backwards. The Fed doubled interest rates first, then recession, then recovery when the Fed slashed rates. This is the exact opposite of your 'bubble/bust' story. If that was the case the Fed would have began with lower rates, created a bubble, and then raised them after the crash to spur rapid recovery. Instead the recession you cite as an Austrian example of gov't best practices actually used STIMULUS to spur recovery!

liberty writes:

"Unemployment is measured by those in the domestic market looking for work. The war didn't generate recovery by putting everyone in the army. Those who weren't drafted could have still, in theory, found difficulty finding work at home and remained unemployed. They didn't, the economy boomed and even with large numbers of women entering the workforce there were plenty of jobs to be had."

... right, but when you send millions of able-bodied working aged men overseas, someone needs to fill their jobs. Why do you think suddenly women all started getting jobs during WWII? Because *someone needed to do that work, and all the able-bodied men had been sent overseas!*

Anyway - you have basically asked: why was there a recession after WWI that last 2 years, and which you blame the war for (although in other places you say that WWII was *good* for the economy), while there was no post-WWII recession.

You ask: "By your theory 1919 should have been the trivial recession [yes, it was only two years, not 15] that didn't even make it since the gov't didn't make such a dramatic drain on the economy and moved quickly out of the way when the war was over. In contrast WWII was the opposite. The gov't's impact on the economy was massive, it was slow to repeal many of the direct wartime economic measures and it didn't repeal the major New Deal provisions from the previous decade. Where was the massive post WWII correction from the massive neglect of following your policy advice?"

My answer: why post-WWII? The massive long depression was the one that lasted from 1929 through 1946. The 1946 output level might have looked good - massive borrowing and wartime spending makes a big aggregate number, but is not so good in terms of standard of living, etc.

You are suddenly trying to start the clock at 1945, but the policies are what dragged the economy down from 1929 when the stock market crash was basically *identical* in size to the 1920 crash.

I am not starting from wartime but from crash-time.

Finally on the Fed's policy in 1920-1921, you say:

"Second, you got the Fed's intervention backwards. The Fed doubled interest rates first, then recession, then recovery when the Fed slashed rates. This is the exact opposite of your 'bubble/bust' story. If that was the case the Fed would have began with lower rates, created a bubble, and then raised them after the crash to spur rapid recovery. Instead the recession you cite as an Austrian example of gov't best practices actually used STIMULUS to spur recovery!"

Um... no. The Fed lowered rates before and during WWI and created a bubble and boom. Then you had the 1920 crash, and then the Fed actually raised rates - a short recession followed, and then (with the Fed doing basically nothing) the economy recovered. The Fed did not use "stimulus" during the recovery (1920-22) at all.

At least, this is my understanding. I know only what I've read from secondary sources, though. As I said, I am not a monetary economist -- but, obviously, I have read about the monetary policy used.

Some secondary sources (though you might dismiss them as Austrian propaganda, I guess):

http://www.thefreemanonline.org/featured/the-depression-youve-never-heard-of-1920-1921/

http://mises.org/daily/3788

Lord writes:

"That's easy."

Not so easy. Consumption goods production should be faster to adapt then, preventing the capital goods bust from becoming an economy wide bust. About the only way to make sense of Austrianism is if the capital goods boom calls forth otherwise unemployed resources for production that prove unsustainable, but it really doesn't affect consumption goods production. The bust is in effect not a bust at all, just a return to the sustainable level of employment and production and the appropriate response is to do nothing and quit complaining, the unemployed shouldn't have had jobs and those capital goods should have never been produced to begin with. Markets never fool themselves, but are always fooled by government.

Doc Merlin writes:

'Second, you got the Fed's intervention backwards. The Fed doubled interest rates first, then recession, then recovery when the Fed slashed rates. This is the exact opposite of your 'bubble/bust' story. If that was the case the Fed would have began with lower rates, created a bubble, and then raised them after the crash to spur rapid recovery. Instead the recession you cite as an Austrian example of gov't best practices actually used STIMULUS to spur recovery!'

Another possible explanation is that the rate raise was a policy miss-step that popped the bubble and crashed the economy. The rate raise was inevitable, however, because inflation finally started rising pretty steeply.

Boonton writes:

OK Lord, it would seem the post WWII US experience poses a massive falseification of the theory.

In WWII a massive capital boom was generated by gov't. Factories were retooled from making cars and consumer goods to planes, tanks and ships. Just about every company became a supplier to the gov't.

From what I have read here, the result of this should have been a crash. When the war ended the gov't would stop buying tanks, planes and ships. Yes factories could be retooled to make other goods but that wasn't without cost. Why no massive crash? Why no bust and depression as holders of unsuitable capital goods went bankrupt and new companies formed to 'mop up' massive amounts of unemployed labor and capital at fireside sales for the 'new economy'?

Yet we have a post-WWII blip rather than recession and a post-WWI heavy recession! Yet the post-WWI period involved a much smaller transition with a gov't supposedly following policies more in line with Austrian recommendations!

Boonton writes:

Doc:

Another possible explanation is that the rate raise was a policy miss-step that popped the bubble and crashed the economy. The rate raise was inevitable, however, because inflation finally started rising pretty steeply.

OK but the 'recession' seemed to be cured by a huge rate cut. In other words, monetary stimulus. I entered this thread by asking what would Austrians have us do no? Would they have not had the Fed performing the massive stimulus they have been doing? Would they have them raising rates? Would they have given us a shorter, but worse, recession in exchange for a faster recovery? No one here carrying the water from Austria's mountains seems willing to provide a clear answer....yet the 'model recession' offered the Fed's policy seems to be more along the lines of Professor Krugman's way of thinking!

What happened now at the end of WWII? Did a bubble need to be 'popped' by the Fed with a rate increase? If not then why wasn't there a post-WWII super crash? After all, don't unpopped bubbles end up popping later one with even bigger explosions?

Bob writes:

As a former day-trader I sum it thus:

Fear is a greater motivator than greed. When the bear is chasing you rational decision making goes out the door.

Allan Walstad writes:

Lord: In response to my earlier comment, your claim about the relative speed of adaptation of consumption versus capital goods industries is irrelevant. If easy Fed money stimulates unsustainable capital projects, which it surely does, then it wastes resources and makes society less productive than it would otherwise be. The investment is intended to pay off after people have been hired, capital goods have been assembled, raw materials have been acquired, and production and distribution are underway. If a lot of artificially stimulated capital projects fail, of course it will cause a fall in production until the misallocated resources, including labor, can be reallocated. That's a recession. If government intervention frustrates the reallocation process it makes things worse.

Simple consumption goods are by definition not purchased or built for the purpose of generating further comsumption goods that might or might not themselves come to fruition or fetch the anticipated price. I buy a TV to have a TV, and when I buy it it's mine. I don't embark on a project to build a TV in the hopes of making a profit. Nor am I hiring employees to build TVs, who will be fired if I miscalculated costs and demand. If I WERE hiring workers and puchasing raw materials and building TVs, then I would be engaged in a capital project which, if it fails, wasted resources and labor and contributed in its small way to economic disruption.

Your assertions about "the only way to make sense of Austrianism" are simply that: your assertions. If you have trouble making sense of Austrianism, it does not necessarily mean that Austrianism doesn't make sense.

Boonton writes:

Allan,

If easy Fed money stimulates unsustainable capital projects, which it surely does, then it wastes resources and makes society less productive than it would otherwise be. ...That's a recession.

How does WWII square with this. The gov't was spending massive amounts on war material. Clearly a massive amount of capital projects had to be started to supply war material. Those projects must have failed or lost value when the gov't ceased needing the various goods they produced. There must be a recession!

If government intervention frustrates the reallocation process it makes things worse.

But gov't was intervening. Price controls were continued even after the war ended, presumably lowering the return to capital switching over to consumer goods thereby hurting the 'reallocation process'. Generous benefits were voted in favor of returning GI's thereby harming their incentive to accept low wage employment at firms trying to realign themselves. Yet no major recession!

Instead we get a post WWI recession when the 'unsustainable capital' boom was much smaller (the US didn't enter WWI until late in the game, and the impact on the economy, while large, was hardly as major as WWII!) and gov't attempts to 'frustrate the reallocation process' appear to be nil.

Allan Walstad writes:

Boonton, federal intervention in the economy in WWII made people much, much poorer. It was not just a matter of pumping in fiat money, stimulating unsustainable capital projects. It was a massive diversion of resources into weapons, and labor into fighting. No major recession? What would we have receded from? I'd suggest the biggest lift to the postwar economy was the absence of FDR's destructive presence. The recovery is a big problem for Keynesians, not Austrians.

In the absence of massive Fed meddling, the recession after WWI was sharp, over quickly, and followed by rapid economic growth, in accordance with Austrian theory.

Lord writes:

Why are there booms and busts? Because they are asymmetric? Because booms are slow and busts are fast? Because profits come slow and losses come fast? Because there are booms and busts? What we have here are descriptions, not explanations. One could assert it is fundamentally because people are loss adverse, but what one needs is an explanation of the process and mechanism whereby this is translated into macro effects, tests to distinguish this from other scenarios, and evidence that this is in fact the case. Why is one slower and one faster? Is this simply a random walk where a long enough sequence of heads induce us to increase the size of our wagers until tails shows up? Are booms and busts inevitable? This is already far beyond Austrianism which at best is a description of a few prominent characteristics of booms and busts.

Boonton writes:

Allen

It was not just a matter of pumping in fiat money, stimulating unsustainable capital projects. It was a massive diversion of resources into weapons, and labor into fighting

This is just saying the same thing, a factory making thousands of tanks and ships every year is an unsustainable capital project (assuming the war is finite). When the war is over the factory has only a fraction of its business. The factory is either worthless or has lost a lot of value since it must retool to make other products.

No major recession? What would we have receded from? I'd suggest the biggest lift to the postwar economy was the absence of FDR's destructive presence.

Well http://en.wikipedia.org/wiki/Great_Depression_in_the_United_States has two helpful charts.

First is GDP, we surged from about $1T right before 1930, fell down to maybe $750B then came back to around $1T after FDR's supposedly bad policies. Yes the recession in 1937 is there but its a minor downturn before the big take off in 1940. WWII took us up to $2T. Post WWII there was a downturn to maybe $1.750T but we were back to $2T in half a decade and growth was steady since then. The idea that the wealth produced in WWII was an illusion because it was all for the gov't doesn't pan out.

Now war goods are clearly very different from consumer goods. They are a good example of Keynes's line about burying money in caves, better to build houses but if the political situation makes that impossible it would work. If Hitler and Japan weren't causing us trouble I don't see how a massive stimulus program of infrastructure and more consumer oriented items couldn't have produced at least the same performance....if not better since we would have all the young people whose lives were ended in the war with us contributing their ideas and labor to our economy.

Second, the unemployment rate graph does show less impressive performance during FDR's reign but even so we were clearly recovering until the recession of 1937 which didn't put us back to sqare one. The super draw down in unemployment, though, came after 1939. A more detailed graph might be helpful here. For the US the war really started in 1942 (Pearl Harbor was Dec-1941 so I'm sure the huge draw down of labor into the armed forces got into swing in 1942.

What's problematic about juding economic performance by the unemployment rate is that its a ambigious metric. You can see an improvement in unemployment because the economy is so bad workers decide to not even bother looking for work. Likewise if the economy picks up a bit those 'disenchanted workers' could come back into the market and actually cause the rate to drift up! Only the really dramatic swings in the rate are clear. Better to use a metric like total employment, total wages, total hours worked etc. if you're going to use this.

I'd suggest the biggest lift to the postwar economy was the absence of FDR's destructive presence.

Are you talking about economic policy or are you saying FDR was just so spooky his absence caused the economy to get better! After WWII gov't intervention in the economy was massive. The New Deal was left in place, Truman even tried to expand it to cover health care. The GI Bill was a massive stimulus program as was the Marshall Plan which stimulated Europe, indirectly boosting US exports. Even the less Keynesian policies like price controls, rationing, cartelization through unionization continued after WWII. Do you seriously have any actual facts to demonstrate that US economic policy post WWII was more Austrian than post WWI?!!! Or is this just argument by partisanship? FDR became a hero for Keynesians so he must therefore be a villian for Austrians. In reality the US has never elected an economist dedicated to any school of throught to President. You won't find a single President who is a clear embodiment of any school of thought.

Boonton writes:

Lord

Why are there booms and busts? Because they are asymmetric? Because booms are slow and busts are fast? Because profits come slow and losses come fast? Because there are booms and busts?

I think this is a problem for Austrians, they are living in upside down world! Austrians seem to imply that bubbles are a bigger danger than busts. But bubbles work against gravity, busts are flowing with gravity. Things like asymetric loss aversion (people would rather have 100% gurantee of getting a return of $50 than a 50% chance of getting $75 and 50% chance of getting $0) to me imply that its the bust that is more dangerous. The economy is more likely to overshoot on its way down wiping out not just the 'unsustainable capital projects' of the bubble but a lot of worthwhile and perfectly sustainable capital projects that were not generated by the delusions of the bubble but will get wiped out in the panic of the bust.

liberty writes:

Probably too late, but on FDR, WWII and policies of 1946:
OPINIONAPRIL 12, 2010
Did FDR End the Depression?

http://online.wsj.com/article/SB10001424052702304024604575173632046893848.html

Frank writes:

this still doesn't answer what causes the boom and subsequent crash, which is Krugman's point.

As he says, Austrian's implicitly assume a rise and fall (whether asymmetric or not) in aggregate demand instead of explaining why there is a fall in aggregate demand or how we can combat this fall (it's also assumed here that the demand was "fake" - a common morality play Austrians use).

Austrian's also assume that this "misallocation" is caused by low interest rates which is caused by the Fed and the Government. Another morality play. Mr. Kling has even said before that he does not believe monetary policy to be particularly effective even in normal times -

"In fact, I think that it is almost always true that monetary policy is ineffective, because it is almost always true that money and other assets are close substitutes. In Can Greenspan Steer?, I pointed out that long-term interest rates were falling (this was August of 2002) even though Fed policy was to hold rates steady."

So you then go back and realize that the Austrian story of business cycles doesn't hold water or is trivial because of 3 things

1) Implicitly assuming increases and decreases in aggregate demand coincide with booms and busts in investments but if we're to believe in Hayekian triangles aggregate demand should fall as (over)investment increases. In other words, a drop in I should be replaced by an increase in C, and vice versa, but clearly that isn't the case. Both C and I increase lockstep and eventually a drop in C leads to a bust in I as C can no longer keep up with I.

2)The Fed is not so powerful at controlling long-term rates. Short-term rates, sure, but long-term rates, hardly, even given QE it can be difficult without sufficient liquidity.

Tyler Cowen also writes -
"Basically he's [Krugman] right, as I've argued in my book Risk and Business Cycles. Here's a bit of what he is serving up:

What happens, instead — or at least that’s how I read it — is that Austrians slip Keynesianism in through the back door. Implicitly, they associate booms and slumps with rising or falling aggregate demand — utterly unaware that their own theory doesn’t actually make room for such a thing as aggregate demand to exist, or at least to affect overall employment. So Austrians are basically Keynesians in denial — self-hating Keynesians? — pretending to themselves that they’re not using ideas that are in fact essential to their story.

Sraffa first made a related point in 1932, though without reference to Keynesianism of course. The strongest defense of the Austrians is something like the following. The simplest IS/LM or AD models are models of flows, not stocks. Arguably the Austrians could be pointing to a longer-run stock condition -- concerning capital, savings, and the like -- which means that the flows of the boom eventually must be reversed into a bust. The Austrians could (though many don't) buy into Keynes as a good short-run theory while addending these longer-run considerations of sustainability.

Krugman's point is harder to rebut if you ask the simple questions of why Austrians a) start from an assumption of full employment, b) postulate that in a boom capital goods production rises at the expense of consumer goods production, and c) argue that real wages rise during the boom. Those can't all happen together.

A separate question is why investors don't see inflation, get scared, and contract the structure of production immediately, rather than first expanding it. Or why unforeseen inflation (if indeed it is unforeseen) does not significantly lower the real interest rate that is paid ex post on borrowed funds (no Fisher effect!), thus supporting long-term investments. Or why investors so respond to the short-term interest rate but are so oblivious to the information contained in the broader term structure. Or just ask how much investors estimate future consumer demand by looking at interest rates -- usually not much at all and so they are not so strongly tricked by monetary influences on intereest rates."

3) The expansion and huge boom of credit derivatives and advanced financial products (the greatest sources of credit - and CDS's being the major cause of failure in AIG) by financial institutions was not made possible from government intervention. It was made possible by there being very little intervention in that market.

Invisible Finger writes:

"The same thing happens to the stock market. After a bust, people test the "waters." They put a little money in and wait. If no disaster happened, they put in a little more. Caution makes us take risks slowly and only after little successes. But when bad news hits, everyone hits the exits at the same time. "

I call my theory the Pool Turd Theory.

You see a nice clean pool full of water, no one else is in it. Maybe it's too cold. So you dip your toe in, gauge the temp, then if it's comfortable you put both feet in. You get acclimated, eventually you submerge yourself and swim. You get out, go to the diving board, and jump in again because you know what it will feel like.

Then someone else sees you swimming, diving, having a good time. But they don't jump right in, they dip their toes in just like you did. After a time they submerge themselves just like you did. Then a 3rd person shows up, then a 4th, 5th, etc. Eventually 30 people are in the pool, all of them dipped their toes in first and got acclimated but they're now all swimming and diving and having a good time.

Then someone sees a pool turd and yells DOODIE!! And everybody gets out of the pool as fast as they can.

Then someone who doesn't know a thing about cleaning pools shows up and grabs a skimmer and removes the pool turd. But none of the 30 people who were in the pool go back in it.

Then a 31st person shows up, dips his toes in, get acclimated. Swimmer #7 yells over to him "Hey you, there was a pool turd in there ten minutes ago. Why do you think none of us are in there?"

So #31 has to make a choice. And none of his options are going to be 100% rational.

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