This article originally appeared on mises.org, Monday, January 24, 2011

As many readers already know, last week Paul Krugman linked to one of my Mises Daily articles explaining the importance of capital theory in any discussion of the business cycle. Although Krugman graciously described my fable about sushi-eating islanders as “the best exposition I’ve seen yet of the Austrian view that’s sweeping the GOP,” naturally he derided the approach as a “great leap backward” and a repudiation of 75 years of economic progress since the work of John Maynard Keynes. To bolster his rejection, Krugman listed several problems he saw with the Austrian understanding.

In the present article I’ll first summarize the Austrian (in the tradition of Ludwig von Mises) positions on capital theory, interest, and the business cycle. With that as a backdrop, I will then answer Krugman’s specific objections.

The Austrians on Capital

In contrast to mainstream macro models, which either do not possess capital at all or at best denote it as a homogenous stock of size “K,” Austrian theory explicitly treats the capital structure of the economy as a complex assortment of different tools, equipment, machinery, inventories, and other goods in process. Much of the Austrian perspective is dependent on this rich view of the economy’s capital structure, and mainstream economists miss out on many of the Austrian insights when they make the “convenient” assumption that the economy has one good. (Krugman will be glad to know that yes, I can spell all this out in a formal model — and one that referee Paul Samuelson grudgingly signed off on. )

Krugman and other Keynesians stress the primacy of demand: they keep pointing out that the owner of an electronics store, say, won’t have the incentive to hire more workers, and buy more inventory, if he doesn’t expect consumers will show up with money to spend on new TVs or laptops.

But Austrians point out that demand per se is hardly the whole story: Regardless of how many green pieces of paper the customers have, or how much credit the store can get from the bank, it will be physically impossible for the electronics store to fill the shelves with new TVs and laptops unless the manufacturers of those items have already produced them. And in turn, the manufacturers can’t magically create TVs and laptops merely because the demand for their products picks up; they rely on other sectors in the economy having done the prior preparation as well, such as mining the necessary metals, assembling the proper amount of tractor trailers needed to ship the goods from the factory, and so on.

These observations may strike some as trivial, not worthy of the consideration of serious economists. But that’s only because normally, a market economy “spontaneously” solves this tremendous coordination problem through prices and the corresponding signals of profit and loss. If someone had to centrally plan an entire economy from scratch, there would be all sorts of bottlenecks and waste — as the actual experience of socialism has shown.

Without the guidance of market prices, we wouldn’t observe a smoothly functioning economy, where natural resources move down the chain of production — from mining to processing to manufacturing to wholesale to retail — as neatly depicted in macro textbooks. Instead, we would see a chaotic muddle where the various interlocking processes didn’t dovetail. There would be too many hammers and not enough nails, too much perishable food and not enough refrigerated railroad cars to deliver it, and so on.

The Austrians on Interest

When it comes to explaining the coordinating function of market prices, Austrians assign a very important role to interest rates, for they steer the deployment of resources over time. Loosely speaking, a high interest rate means that consumers are relatively impatient, and penalize entrepreneurs heavily when they tie up resources in long-term projects. In contrast, a low interest rate is the market’s green light to entrepreneurs that consumers are willing to wait longer for the finished product, and so it is acceptable to tie up resources in projects that will produce valuable goods and services at a much later date.

In the Austrian conception, it is the interest rate that allows the financial decisions of households to interact with the physical capital structure, so that producers transform resources in the ways that best satisfy consumer preferences. Consider a simple example that I use for undergraduates: Suppose the economy is in an initial equilibrium where households save 5 percent of their income. Then the households decide that they want to have more for their retirement years, because they don’t want their standard of living to plummet once they stop working. So all the households in the community begin saving 10 percent of their income.

In the Austrian view, the interest rate is the primary mechanism through which the economy adjusts to the change in preferences. (It’s not that people switched from buying hot dogs to hamburgers; instead they switched from buying “present consumption” to buying “future consumption.”) The increased household saving pushes down interest rates, and at the lower rates businesses can start long-term projects. From the individual entrepreneur’s point of view, the interest rate affects the profitability of longer projects more than shorter ones (as a simple “present-discounted-value” calculation shows). So a lower interest rate doesn’t merely stimulate “investment” but actually gives a greater inducement to investment in durable, long-term goods, as opposed to investment in nondurable, short-term goods.

How is it possible that the community as a whole can have more income in, say, 30 years? Obviously the households think it is financially possible, because their bank balances rise exponentially with the higher savings rate. But technologically speaking, this is possible because the composition of physical output changes. The households have cut back on going out to dinner, buying iPods, and so on, in order to double their savings rate. This means that restaurants, Apple stores, and other businesses catering to consumption will have to lay off workers and scale back their operations. But that means labor and other resources are freed up to expand output in the sectors making drill presses, tractors, and new factories.

In 30 years, the economy will be physically capable of much higher output (including the production of consumer goods), because at that time, workers will be using a larger accumulation of capital or investment goods made during the previous three decades. That is how everybody can have a higher standard of living, through savings.

The Austrians on the Business Cycle

Now that I’ve given a summary of the Austrian view of capital and interest, we get the reward: their explanation of the business cycle. When interest rates are pushed down below their market levels (by expansionary central-bank policy, for example), this sets in motion the same processes that would occur if there were an actual increase in savings. In other words, at the lower interest rate, entrepreneurs find it profitable to begin long-term projects; the capital-goods sectors of the economy begin hiring workers and increasing output.

However, this expansion of the capital-goods sectors isn’t counterbalanced by a shrinking of the consumption-goods sectors, the way it would be if households actually started saving more. Instead, the households try to consume more too, because of the lower interest rates.

An unsustainable boom sets in, a temporary period of illusory prosperity. Because every sector is expanding, there is a general feeling of euphoria; it seems every business is having a “great year,” and the unemployment rate falls below its “natural” level.

Unfortunately, at some point reality rears its ugly head. The central bank hasn’t created more resources simply by buying assets and lowering interest rates. It is physically impossible for the economy to continue cranking out the higher volume of consumption goods as well as the increased output of capital goods. Eventually something has to give. The reckoning will come sooner rather than later if rising asset or even consumer prices makes the central bank reverse course and jack up interest rates. But even if the central bank keeps rates permanently down, eventually the physical realities will manifest themselves and the economy will suffer a crash.

During the bust phase, entrepreneurs will reevaluate the situation. If the government and central bank don’t interfere, prices will give accurate signals about which enterprises should be salvaged and which should be scrapped. Those workers who are in unsustainable lines will be laid off. It will take time for them to search through the developing opportunities and find a niche that is suitable for their skills and is sustainable in the new economy.

During this period of reevaluation and search, the measured unemployment rate will be unusually high. It’s not that workers are “idle,” or that their productivity has suddenly dropped to zero; rather, it’s that they need to be reallocated, and that takes time in a complex, modern economy. This delay can be due to simple search, where the workers have to look around to find the best spot that is already “out there,” or it can be due to the fact that they have to wait on other workers to “get things ready” before the unemployed workers can resume. (This is what happened in my sushi story.)

I’ll stop the summary at this point in order to address Krugman’s objections. The interested reader can see more technical (yet still accessible) expositions in this collection of essays, while those interested in a graphical exposition (using mainstream concepts such as the PPF) should check out Roger Garrison’s fantastic PowerPoint presentations.

Answering Krugman

My reason for the lengthy summary is that I still get the sense that Krugman truly doesn’t understand the Austrian position. For example, he asks, “Why is there overwhelming evidence that when central banks decide to slow the economy, the economy does indeed slow?” But because the Austrian theory says the bust occurs when the central bank backs off and allows interest rates to rise toward their “correct” level, this is hardly a problem. In fact, if central banks couldn’t slow the economy, as an Austrian economist I would be worried about my theory.

Krugman also poses questions concerning (price) inflation rates and the connection between nominal and real GDP. But I think he is conflating the Austrian theory with a purely “real” business-cycle theory. Austrians understand that monetary influences can have real effects. To repeat, that is the very essence of the Mises-Hayek theory.

Although most of Krugman’s objections are due to his unfamiliarity with the actual Austrian theory, I think one source of confusion came from the particular illustration I used in my article. First let’s set the context by quoting Krugman:

So what is the essence of this Austrian story? Basically, it says that what we call an economic boom is actually something like China’s disastrous Great Leap Forward, which led to a temporary surge in consumption but only at the expense of degradation of the country’s underlying productive capacity. And the unemployment that follows is a result of that degradation: there’s simply nothing useful for the unemployed workers to do. I like this story, and there are probably other cases besides China 1958–1961 to which it applies. But what reason do we have to think that it has anything to do with the business cycles we actually see in market economies?

First, I should say I’m glad that Krugman at least concedes that (his understanding of) the Austrian explanation both is theoretically possible and actually happens in the real world — coming from the guy who referred to it in 1998 as equivalent to the “phlogiston theory of fire,” this is progress!

However, Krugman still doesn’t have quite the right understanding of the Austrian view of the “capital consumption” that occurs during the unsustainable boom. As I said above, on this particular issue the fault lies with the necessarily simplistic “sushi model” I used in the article that Krugman read.

In that article, in order to make sure the reader really saw why Krugman (and Tyler Cowen) were overlooking something basic, I had the villagers boost their daily sushi intake even while they developed a new technology to help augment their fishing. So during their “boom,” it would have seemed to a dull villager that both consumption and investment were rising.

In my fable, this was physically possible because the villagers neglected the regular maintenance of their boats and nets. This neglect wouldn’t show up overnight, but eventually the village economy would crash. To repeat, I chose this illustration to make basic points about the capital structure and how short-term consumption binges can be physically possible, but must still be “paid for” in the long run.

Unfortunately, my fable and the lessons I drew from it gave the impression (see Tyler Cowen’s critique) that the Austrians think the “capital consumption” during the unsustainable boom period must show up in things like reduced spending on building maintenance, or perhaps in the owner of a fleet of trucks neglecting to have the tires rotated.

In reality, it’s more accurate to say that during the boom period, entrepreneurs (led by false signals) invest in projects that are individually rational and “efficient,” but that don’t mesh with each other. In other words, it’s not so much that a farmer forgets to plant some of the seed corn in order to have a future crop. Rather, it’s that a farmer plans on expanding his output, and so he plants much more than he did in the past, but unbeknownst to him, the owners of the silos and railroads (needed to bring the harvest to market) aren’t expanding their own operations at the same pace.

In summary, it’s not that the Austrians think an inspection of an individual enterprise will reveal a technological deficiency. Rather, it’s that all of the entrepreneurs are “getting ahead of themselves,” trying to develop too quickly. There aren’t enough real savings to allow all of the new processes to be completed. To capture this aspect of the Austrian theory, Mises’s analogy of a homebuilder (who draws up blueprints thinking he has more bricks than he really does) is still the best.

Krugman Wants to Know: Where’s the Evidence?

This leads into Krugman’s central complaint:

Oh, and what evidence is there that the economy’s capacity is damaged during booms? Investment rises, not falls, during booms; yes, I know that Austrians take refuge in cosmic talk about the complexity of production and how measured investment may not show what’s really happening, etc., but where’s the positive evidence of what they’re claiming?

I can sympathize with Krugman, but there is no simple statistic to which we can point. Austrians are correct to say that “measured investment may not show what’s really happening,” and correct to say that production is much more complex than depicted in Krugman’s models. This isn’t “cosmic talk” but a statement of basic facts.

But to answer his question, Austrians certainly can point to positive evidence of their view. For example, Austrians argue that during the housing boom years, Americans didn’t save enough out of their wage and salary income, because they were misled into thinking they were much wealthier than they really were. Then when reality set in the illusion was shattered, and valuations of capital assets fell sharply. Realizing they had made terrible decisions during the boom, Americans sharply increased their savings. The data match this story pretty well:

The above chart shows that the savings rate (blue) plummeted during the peak years of the housing bubble, as the S&P 500 (red) zoomed upward. Then in late 2007 the stock market began crashing, while the savings rate increased very sharply. The stock market turned around in early 2009, of course, but from the Austrian perspective, this is because the Fed’s massive interventions — capped off by the first round of “quantitative easing” (which was announced at this time) — started artificially blowing up asset prices again.

We can also get hard empirical support for the Austrian claim that the housing boom drew an unsustainable amount of real resources (including labor) into that sector, which eventually collapsed and caused a spike in unemployment. The following chart compares total construction employment (blue line) with the home vacancy rate (red line), which is a good indication of a speculative bubble: people were buying homes not to live in, or even to rent out, but to “flip” when the price went up. Notice the connection between the speculative housing bubble and the workers sucked into — and then expelled from — construction:

When it comes to applying the generic Austrian theory to the recent boom-bust cycle, we have to think globally. During the boom, much of the rising stream of consumption goods enjoyed by Americans was physically produced in China and other foreign countries. To put it in terms Krugman will appreciate, we could say that the boom period’s surge in imports (which “subtract” from GDP) was consistent with a “healthy” string of GDP increases, not because of counterbalancing exports, but rather because Americans and their government kept spending more and more each year (thus boosting C, I, and G), more than offsetting the growing trade imbalance.

There is nothing wrong with a trade deficit (or more accurately, a current account deficit) per se; elsewhere I explained how a very healthy and sustainably growing economy could have an indefinite stream of such deficits, as the rest of the world rushed to invest in a country blessed with attractive policies.

But when it comes to the actual housing boom under George W. Bush, Americans’ accumulation of SUVs, plasma-screen TVs, and gaming consoles was clearly unsustainable. This is not because — as in my sushi story — Americans were forgetting to do standard maintenance. Rather, it is because Americans couldn’t possibly have kept “total output” — which is very imperfectly captured in our official GDP figures — at the dizzying height at the end of the boom period, because it required foreign producers to continue sending us goodies in exchange for ownership claims on a growing collection of McMansions in which nobody could afford to live.

To make sure that this intuitive story fits the facts, we can chart an index of home prices (blue) against the current account balance (red). The figure below illustrates quite nicely that as the housing bubble inflated, the current account sank more deeply negative. Then the housing bubble and the trade deficit both began collapsing at roughly the same period, as American consumers (and foreign investors) came to their senses.

Of course, Krugman’s models and interpretation can incorporate the above evidence too. So he could understandably claim that he has no reason to credit the Austrian view over his own.

But I can point to at least two episodes where the “sectoral-readjustment” story of the Austrians clearly has more explanatory power than Krugman’s “insufficient demand” story. Specifically, in late 2008 Krugman argued that the housing bust had little to do with the recession, because the latest BLS figures showed that unemployment at the state level bore little relationship to the declines in home prices across the states.

However, I pointed out that looking at year-over-year changes in unemployment at the end of 2008 was hardly the right test. If we looked at changes from the moment the housing bubble burst, then five of the six states with the biggest housing declines were also in the list of the six states with the biggest increases in unemployment.

On another occasion (last summer), Krugman once again thought he had dealt the readjustment story a crushing blow when he pointed out that manufacturing had lost more jobs than construction. I pointed out that this too wasn’t a valid test, because manufacturing had more workers to begin with. When we looked at percentage declines, then construction did indeed crash more heavily than manufacturing. Furthermore — and just as Austrian theory predicts — the employment decline in durable-goods manufacturing was worse than in nondurable-goods manufacturing, while the decline in the retail sector was lighter than in the other three.

These are very important episodes. When Krugman thought the numbers were on his side, he was happy to cast aspersions on the sectoral-readjustment story; he thought his own model was perfectly able to explain the situation if the crash in housing really didn’t have much to do with the upheaval in the labor markets. And, as Krugman himself argued, had he been using valid tests, then the outcomes would indeed have been challenging to the Austrian story.

So now that we see the changes in employment really do match up with the Austrian explanation, we should be much more confident that it is capturing at least an important part of the story. To repeat, I didn’t set out to find data that matched the Misesian exposition and then finally settled on some charts that did the trick. Rather, Krugman thought he had found a falsification of the theory, but it turned out he had conducted a poor experiment.

Because Krugman was the one who set up these two challenges, it is significant that the Austrian theory passed with flying colors. Furthermore, it is significant that Krugman’s own theory cannot explain the actual sectoral shifts in the labor markets. Remember, Krugman wasn’t at all embarrassed by the data when he (erroneously) thought the housing bubble had little to do with the unemployment problem.

This is very important, because it was Krugman who notoriously advocated (in 2002) and then defended (with caveats in 2006) the creation of a housing bubble.

I am not engaging in a character attack or “gotcha” by pointing this out: it is very significant that Krugman’s model prescribed a housing bubble as a solution to the dotcom crash, even though — as we’ve seen — Krugman’s model is obviously inferior to the Austrian explanation when it comes to assessing the fallout from the housing bubble.

Conclusion

I do not claim that the Austrian theory of the business cycle captures every pertinent feature of modern recessions. What I do claim is that a theory — including any of Paul Krugman’s Keynesian models — that neglects the distortion of the capital structure during boom periods cannot possibly hope to accurately prescribe policy solutions after a crash.