I'm sending this again. Not sure it
made it to the list first time. If it did, please
ignore.
Ed Weick
From time to time, some members of this
list have voiced a grievance against Paul Krugman, the
MIT economist because he has appeared to dismiss "the Austrians", proponents of one of the last
great schools of classical economics. I've argued that, no, he doesn't really dismiss them. What
they say is of no interest to him. I was wrong. He dismisses them. More than that: in an article
in the January-February issue of Foreign Affairs entitled "The Return of Depression Economics",
he argues that they are wrong and have virtually nothing useful to say to the present day world.
MIT economist because he has appeared to dismiss "the Austrians", proponents of one of the last
great schools of classical economics. I've argued that, no, he doesn't really dismiss them. What
they say is of no interest to him. I was wrong. He dismisses them. More than that: in an article
in the January-February issue of Foreign Affairs entitled "The Return of Depression Economics",
he argues that they are wrong and have virtually nothing useful to say to the present day world.
What Krugman is calling wrong-headed is
the belief that the business cycle can be self-correcting
if it is largely left alone. The Austrian theory of the business cycle holds that boom is inevitably
followed by bust and bust by boom. These oscillations need not be wide, but wide enough to
clear out bad investments during busts and reward sound investment during booms. The invisible
hand is at work. During booms, productive factors become increasingly scarce and prices rise to
levels which marginal firms find unaffordable. They fail, freeing up productive resources and
causing prices to fall. At some point, prices will again be low enough to permit reinvestment and
the economy will begin to grow. Supply will have created its own demand, and the system moves
on. The proper role of government in all of this is minimum interference. If government has any
role at all, it is to help the system to self-correct by, for example, cleaning out the dead wood and
corruption in the banking system and combating rigidities in capital and labour markets -- in
other words, by ensuring that the system keeps moving toward competition and efficiency.
if it is largely left alone. The Austrian theory of the business cycle holds that boom is inevitably
followed by bust and bust by boom. These oscillations need not be wide, but wide enough to
clear out bad investments during busts and reward sound investment during booms. The invisible
hand is at work. During booms, productive factors become increasingly scarce and prices rise to
levels which marginal firms find unaffordable. They fail, freeing up productive resources and
causing prices to fall. At some point, prices will again be low enough to permit reinvestment and
the economy will begin to grow. Supply will have created its own demand, and the system moves
on. The proper role of government in all of this is minimum interference. If government has any
role at all, it is to help the system to self-correct by, for example, cleaning out the dead wood and
corruption in the banking system and combating rigidities in capital and labour markets -- in
other words, by ensuring that the system keeps moving toward competition and efficiency.
To Krugman, what is wrong-headed about
this, is not that it is all wrong -- in the long run the
economy may very well work that way -- but that it is wrongly applied to policy. In his essay, he
repeatedly refers to the pre-Keynesian early thirties, when European countries, having recently
experienced hyperinflation, applied extremely parsimonious policies to emerging financial crises.
He argues that essentially the same types of policies are being applied today, and that they are as
wrong now as they were then.
economy may very well work that way -- but that it is wrongly applied to policy. In his essay, he
repeatedly refers to the pre-Keynesian early thirties, when European countries, having recently
experienced hyperinflation, applied extremely parsimonious policies to emerging financial crises.
He argues that essentially the same types of policies are being applied today, and that they are as
wrong now as they were then.
Though there are now signs that the IMF is
reconsidering its approach, a parsimonious approach
to policy has been central to all of its bailouts. The IMF has argued that recovery must be based
on making capital and labour markets more efficient. What it has not recognized, according to
Krugman, is that it is essentially applying long run solutions to economic problems that are
essentially short run. Its policies have encouraged restraint when expenditures are needed, and
have catapulted already bad situations into worsening ones.
to policy has been central to all of its bailouts. The IMF has argued that recovery must be based
on making capital and labour markets more efficient. What it has not recognized, according to
Krugman, is that it is essentially applying long run solutions to economic problems that are
essentially short run. Its policies have encouraged restraint when expenditures are needed, and
have catapulted already bad situations into worsening ones.
The policy instruments by which the IMF's
prescriptions have been applied have involved a mix of
budgetary restraint, higher interest rates and rising taxes, all designed to wring excess out of
failing economies and make countries able to honour their foreign indebtedness and resist
speculative attacks on their currencies. The disease must be cured by the application of leeches to
suck out the blood and by hot baths to shrink the fat.
budgetary restraint, higher interest rates and rising taxes, all designed to wring excess out of
failing economies and make countries able to honour their foreign indebtedness and resist
speculative attacks on their currencies. The disease must be cured by the application of leeches to
suck out the blood and by hot baths to shrink the fat.
Pointing out that such policies will
result in falling effective demand, disinvestment and a fall in
personal consumption, hence large-scale unemployment and falling income, Krugman argues for
the opposite approach. Spend. Lower interest rates. Get the economy moving. Restore
consumer confidence. Get people feeling good about working and earning. If they feel good, they
will buy and invest. Accept that this will be inflationary, and live with it. Krugman recognizes that
this approach will make it difficult for a country to maintain a fixed exchange rate. If it has to let
the value of its currency fall, as most recently Brazil has done, repayment of foreign debt may
become difficult or impossible. Depending on how bad the situation is, it may require the
imposition of exchange controls or other drastic measures to keep capital from fleeing. But
whatever pain will result should not last. The prescription is essentially short run get things
moving and worry about how to keep them moving later.
personal consumption, hence large-scale unemployment and falling income, Krugman argues for
the opposite approach. Spend. Lower interest rates. Get the economy moving. Restore
consumer confidence. Get people feeling good about working and earning. If they feel good, they
will buy and invest. Accept that this will be inflationary, and live with it. Krugman recognizes that
this approach will make it difficult for a country to maintain a fixed exchange rate. If it has to let
the value of its currency fall, as most recently Brazil has done, repayment of foreign debt may
become difficult or impossible. Depending on how bad the situation is, it may require the
imposition of exchange controls or other drastic measures to keep capital from fleeing. But
whatever pain will result should not last. The prescription is essentially short run get things
moving and worry about how to keep them moving later.
Krugman does not consider the possibility
that the pain may not stop. Here he is as vulnerable as
the Austrians. What happens beyond the short run? Another short run, and then another? What
is not recognized (though I'm sure Krugman sees it) is that a lot of dross is carried from one short
run to the next. Eventually, all of this dross becomes the long run, and limits what short run
action may be possible. Here the Austrian's prescription of making certain that the house is kept
in order appears more appropriate. One can dismiss their notions about self-correction, but one
must allow them this truth.
the Austrians. What happens beyond the short run? Another short run, and then another? What
is not recognized (though I'm sure Krugman sees it) is that a lot of dross is carried from one short
run to the next. Eventually, all of this dross becomes the long run, and limits what short run
action may be possible. Here the Austrian's prescription of making certain that the house is kept
in order appears more appropriate. One can dismiss their notions about self-correction, but one
must allow them this truth.
What neither Krugman nor the Austrians
seem to recognize is that many countries are not in a
position to follow either of their prescriptions. In the case of Russia, for example, it has become
evident that no matter how much foreign financial aid is pumped in, nothing much will happen.
The conduits by which such aid is moved to foreign bank accounts are many; the institutions via
which it could do good are simply not there. The continuation of a downward spiral is inevitable.
Or, as Krugman points out, in the case of Japan, institutions, including social obligations, may be
so many and so gridlocked that they are simply unworkable. Japan has fallen into what Krugman,
following Keynes, calls the "liquidity trap". Here saving and investment appear to be independent
of the rate of interest. No matter how low the rate of interest, most people will save but will not
invest. A high proportion of the money supply is held as cash and simply not be put to any
purpose. Policy making in a situation like this is, as Krugman puts it, like pushing on a string.
position to follow either of their prescriptions. In the case of Russia, for example, it has become
evident that no matter how much foreign financial aid is pumped in, nothing much will happen.
The conduits by which such aid is moved to foreign bank accounts are many; the institutions via
which it could do good are simply not there. The continuation of a downward spiral is inevitable.
Or, as Krugman points out, in the case of Japan, institutions, including social obligations, may be
so many and so gridlocked that they are simply unworkable. Japan has fallen into what Krugman,
following Keynes, calls the "liquidity trap". Here saving and investment appear to be independent
of the rate of interest. No matter how low the rate of interest, most people will save but will not
invest. A high proportion of the money supply is held as cash and simply not be put to any
purpose. Policy making in a situation like this is, as Krugman puts it, like pushing on a string.
Ed Weick
