A Simple Reply to Krugman on Austrian Economics By Arnold Kling

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.