Krugman on Austrian business cycle theory

by on April 8, 2010 at 7:28 am in Economics | Permalink

Basically he's 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.

The point is not to throw out the Austrian scenario altogether, but rather to rebuild it with foundations from bubble theories and Keynesian economics, plus modern finance and real business cycle theory.

Addendum: Arnold Kling comments.

1 Constant April 8, 2010 at 8:17 am

“Sraffa first made a related point in 1932, though without reference to Keynesianism of course.”

That sentence seems to suggest that the chronology does not support the claim that the Austrians slipped Keynesianism in through the back door. If anything, it would have to be Keynes who slipped Austrianism through the back door – chronologically speaking.

2 Eli April 8, 2010 at 8:33 am

I am not an Austrian, but I will offer a partial defense. You’re right that a), b), and c) logically cannot happen all at once. And for sophisticated Austrians, that is the point. b) is an illusion. Consumption goods increase because of derived demand, and investments in higher-order goods increase as well. This *must* be financed by rapid depreciation or deterioration of capital in the middle of the structure of production, but this depreciation or deterioration may not be measured by economic statistics. Eventually the structure of production collapses due to this deterioration.

By the way, Tyler, you should blog about *Risk and Business Cycles* more!

3 E. Barandiaran April 8, 2010 at 9:10 am

Tyler, I cannot make any sense of your last sentence. It reads as an ad for a Chefs Academy. Please write a detailed post (or perhaps a paper) on what you consider the main building blocks for a new macroeconomics and forget about references to old theories (who cares about what Mises, Hayek, Keynes, Sraffa or other dead economist said about macroeconomics?) and about comparisons with other living economists’ proposals for reconstructing macroeconomics (we can do them after we understand what you proposing).

Indeed the Mission may be Impossible –thousands of macroeconomists have been working hard for the past 50 years to get beyond what we knew by 1960 (well summarized in Ackley’s textbook) with limited success. Thus why I’m asking you only for the building blocks. One of my many concerns is how to deal explicitly with the systems of payments and financial intermediation (the old macro concept of money must be abandoned) and with the system of public policies (the idea that government policies are exogenous must also be abandoned).

4 MD April 8, 2010 at 9:11 am

“b) postulate that in a boom capital goods production rises at the expense of consumer goods production”

On this point at least, I don’t believe that this is what they in fact claim. The low interest rates that trigger the boom encourage production of *both* higher order (capital) goods and goods closer to immediate consumption. For those who wish clarification on this point, I’d refer you to Roger Garrison’s work on this topic for a more in depth explanation, but as far as what you’re saying here Tyler, I don’t think this is right.

5 Ryan Vann April 8, 2010 at 9:27 am

Constant said,

“Sraffa first made a related point in 1932, though without reference to Keynesianism of course.”

That sentence seems to suggest that the chronology does not support the claim that the Austrians slipped Keynesianism in through the back door. If anything, it would have to be Keynes who slipped Austrianism through the back door – chronologically speaking.

Indeed. Anyway, do Austrains assume full employment? Where does this assertion come from? It is my view that full employment, if not a dynamic target, is a complete myth and should be trashed. Krugman, per usual, is confusing. How do Austrians not allow for demand?

6 DanC April 8, 2010 at 9:55 am

I will admit some confusion. I would not consider myself an Austrian but I’m not sure of Tyler’s attack.

on A) Assume full employment because if the pricing mechanism works then markets clear, even labor markets.

B) during periods of technological advance wouldn’t you expect a shift toward that sector that gives you the greatest return on investment, which is most often the capital goods market. ‘Or perhaps sometimes, based on comparative advantage, some nations will specialize which requires increased investment in capital goods for export at the expense of consumer production for some period.

C) If booms are, at least sometimes, caused by technological innovations that increase productivity, wouldn’t workers who are more productive see increases in wages to capture some of the increased productivity? As some workers specialize in the new technology couldn’t other workers specialize in making those workers more productive. For example, big increase in computer technology drives demand for computer geeks, Those computer geeks specialize in geeky stuff. But they also require various services and goods that make them more productive. They use labor saving devices and services. This increased productivity driven by specialization, or division of labor, leads to higher wages.

I assume the Austrians want to claim that easy credit leads to the investment in projects that do not increase productivity. That projects with very low hurdle rates are financed during periods of easy money. These projects are a search for fools gold that can not continue for long periods.

I’m not saying I agree with the Austrians, just that I’m uncertain of the critics.

7 Andrew April 8, 2010 at 10:25 am

To answer the meta-question, Krugman should have kept up the charade that Austrians weren’t worth grappling with.

I think one answer is that prices and values are not equal. I think the underlying strawman is that Austrians must believe in the hard-form efficient market theory when what we actually believe is that the business cycle is the exception that proves the rule? And what is the explanation for that? That is the part everyone knows, intervention in the ultimate commodity…money.

8 Gabe April 8, 2010 at 11:05 am

You use pop-psychology(“self-hating”)to ridicule a economic school of thought that has proven to be MUCH more useful in predicting our economic future than the Keynesian/Greenspan/Bernankian/Mainstreamism schools. The people magazine level smear attack is laughable…go back to promoting the bailout packages…how is that Paulson Plan working out? Goldman pass along your share?

9 Gabe April 8, 2010 at 11:21 am

I professional use regressions and statistical models every day. In particuluar I use them to help analyze supply and demand fundamentals in various commodity markets and in the larger economy as a whole.

I also used austrian ideas to predict why the 2000’s were going to be a bad decade from a real economic growth perspective…why commodities would outperform equities and why the current 2003-2004″recovery” was of much worse quality than my peers thought…the austrian ideas explain why this “recovery” is built on sand.

I know lots of people who read Human Action, MES etc…without coming away witha hatred towards “math”, regressions or any of the other silly strawmen I see bandied about here.

You guys think this is going to be a fun economic recovery? You think our national trajectory is heading in a good way due to all the smart keynsians we have running the country? good luck. Do what Volcker, Krugman, Bernanke say…raise taxes…put the VAT and CO2 tax in …see what happens. I dare you!

10 Floccina April 8, 2010 at 11:58 am

Can you have a), b), and c) if new money increases the dollars going into investment even while real investment is reduced? I.e. one programmer is paid $1,000,000 per year to create a web site that looses money and must be liquidated but it is not taking much from production just one guy and maybe he invests that money in another internet start up.

11 Seth April 8, 2010 at 12:55 pm

“…is that Austrians slip Keynesianism in through the back door. Implicitly, they associate booms and slumps with rising or falling aggregate demand…”

Is this true?

12 bbartlog April 8, 2010 at 1:13 pm

‘Here’s a reminder of Big Peoples’ involvement in this failure: (..stuff…)’

Um, yeah. And those people weren’t Austrian economists. The people I can think of who were associated with the school were for the most part prescient in describing todays’ problems; most of them saw the bubble no later than 2004-2005, when Greenspan et. al. were still denying it. Also, claiming to be ‘intellectually ready for crises like this one’ is vapid when we have yet to see the final outcome of any of the policies advocated by the Keynesians. After we tally up the human cost of inflation, in let’s say – 2020, maybe we can talk about intellectual readiness and whether Keynesian policies were helpful or disastrous.

13 Lord April 8, 2010 at 1:33 pm

Yes, Austrians can’t explain the bust other than through depletion in stock. Otherwise the failure of capital goods industries would just lead to a boom in consumption goods whose production has been held back by the boom in capital goods. They are rather weak on how the loss in wealth from those malinvestments translate into the incapacity of consumption goods to recover other than their losses leave them with nothing to invest in them. I think they really need to focus on how capital good industries can seem more profitable during the boom, but consumption good industries are not even during the bust.

14 SLM April 8, 2010 at 2:18 pm

“but rather to rebuild it with foundations from bubble theories and Keynesian economics, plus modern finance and real business cycle theory.”

Nice : but we’ll leave this to state-appointed economists, since Keynesian economics expertise seems here required to fit it in.

15 Seth April 8, 2010 at 2:49 pm

Andrew – So Krugman’s and Cowen’s views are straw men?

16 Andrew April 8, 2010 at 3:59 pm

Oh, and while he was busy ignoring the Austrians, he was also waiting for a response to his unemployment question, which never was answered, except it was by Kling and Murphy among others.

17 Andrew April 8, 2010 at 4:20 pm

I think the question is how you think about aggregate demand. Is it mostly a cause or mostly an effect? Why do most of these broad slumps involve some form of peak in credit? Again, mostly a cause or mostly an effect? I’d be pretty shocked if Austrians didn’t believe that psychology plays a role. In fact, the whole theory attempts to explain WHY the market is not efficient during a business cycle. Who ever said that there wasn’t some overlap with Keynesianism? I’ve read chapter 12, there isn’t much I disagree with.

That the definition of “Austrian” equals “Not Keynesian” certainly is a strawman. It is in fact the Keynesians that have tweaked Keynesianism with the main goal of justifying interventions.

As for the theory of the recovery, how’s that working out for you? I know, I know, stimulus too small. If we just had the right guys running the show, etc.

As for the theory of the boom/bust, it’s almost like noone noticed the enormous finance-fueled bubble and all the empty houses all over the place and the central role of the banks. Of course, that must be due to de-regulation. Of course, The Great Moderation was despite all the de-regulation.

18 Rakesh Bhandari April 8, 2010 at 4:53 pm

Oh it’s not clear that they took a nihilistic liquidationist view at all. After all, deLong himself cites von Mises’ support of fascism, and there is evidence that Schumpeter came to the US so that he would not have to argue explicitly for Hitler in the face of colleagues’ opposition. I am referring here to Allen’s two volume biography, though I know McGaw and Swedberg don’t think Schumpeter had clear fascist sympathies. But the diary entries suggest otherwise. And then there is that matter of Keynes’ introduction to the German translation of his General Theory.

19 indianajim April 8, 2010 at 7:54 pm

Keynes took the market for loanable fund “out of play” and gave us the “paradox of thrift”. Capital based macro is a whole different kettle of fish; saving is a means to an end. There is no “free” economic growth, but thrift (lower current consumption) does lead to faster rates of growth eventually leading to higher living standards. Or you can believe Joe Biden that the only way out of government debt is for the government to spend, spend, spend!

Keynes wanted to “socialize” the investment sector because investment is driven by “animal spirits”. Or you can believe Hayek that the structure of capital is guide by the interest rate rather than animal spirits.

In any case Krugmans likening Hayek to Keynes makes little sense to any but the illiteratti.

20 R. Richard Schweitzer April 8, 2010 at 9:05 pm

What? No comments on “information,” its distribution, its interpretation (and Mis-), its accuracy, the speed of its transmission?

21 John Hall April 8, 2010 at 10:55 pm

Craig, I would also refer Tyler to Garrison’s powerpoint where he clearly shows on the Production Possibilities Frontier that both investment and consumption increase during the boom.

22 Jon April 9, 2010 at 1:25 am

Tyler: I disagree with your rendition of the ABCT. In short, I think we can agree that if the Fed practices level targeting, that if when it overshoots the level and then takes purposeful action to deflate in order to return to target, there will be a boom-bust.

ABCT is a gold-standard theory. It embeds per-se that nominal prices will be reset.

That would be the end of it, were there not one more detail: during the boom, the structure of production does expand but the capital stock in real-terms is net liquidating.

Does that matter? Well that depends on which side of the unit-root debate you are on.

Regardless, ABCT is actually the girder under all of modern macro. You’d do well to understand it more deeply, rather than disparage it to burnish your credentials.

23 Andrew April 9, 2010 at 8:21 am

I don’t disbelieve in some of the implications or utility of something called “aggregate demand.” Tyler has forgotten more about ABCT than I’ll ever know, but I think it’s a bit of a stretch to say that an acceptance of one interpretation of some aspects of the macro economy that they Keynesians call aggregate demand makes big enough dent in the distinction of Austrian theory that it can just be assimilated into Keynesianism. Yes, it is an alternative to Keynesianism, or those things that modern-day Keynesians emphasize, but noone claimed it was exact opposite.

7. Originally drafted under Texas avoidng the housing bubble. Fits better here.

Feeling flush with cash (from credit) contributes to the euphoria that has to be depressed in the bust. Why do Keynesians only believe in the back half of the animal spirits? They quite literally bring in Austrian theory through the back door of the boom, only in the bust. If “Keynesianism” equals “Not Austrianism” then they don’t believe in a recalculation, and thus they promise a return to housing euphoria if we simply build a few bridges to prop up aggregate demand. Yes, simply cheer up the investors that got up on the wrong side of the bed and saw their shadow and ran back into their hole and we are back to sub 4% unemployment building houses.

By the way, a relaxing of a restriction on the amount a borrower has to make as a downpayment is not “deregulation” because the fractional reserve system is itself a regulation of the government. It is actually part of the bankruptcy system that the government has control over. By analogy, it would be like saying that a change to the rules of engagement in war is a “deregulation.” No! The whole shooting match is a government program! If the government says to the soldiers “you can shoot the prisoners” that is not a “free market” move.

To be clear, it is not we who said that people behave rationally with free money, it is we who said they most assuredly do not! Why do you think we can’t stand Alan Greenspan?!? This is why I think that it is a sufficient but not necessary condition for capital goods substituted for consumption goods to qualify for an Austrian Business Cycle. But it could be the other way around, or something different entirely. The key (in my mind) is the error and the broad application of the error. To err after all, is human, to really fudge things up requires leverage. The only thing big enough to provide enough leverage for an economy-wide bubble is the government.

Is this recession the worst because of deregulation? See above. But further, I think it is possibly worse because we didn’t even borrow to build overcapacity. We borrowed so that we could send our productive capacity to our lender, if you can believe that! Even Krugman said this was unsustainable! (That is him knocking on the back door.)

“Americans make a living selling each other houses, paid for with money borrowed from the Chinese. Somehow, that doesn’t seem like a sustainable lifestyle.”

So we evolve and assimilate the views of others. I’m thankful Krugman has assimilated just enough Austrianism to then claim that we are all Keynesians now. But anyone claiming to have all the answers is left with the argument that “well, the establishment just didn’t listen to us.” Who has the stronger case for that argument? The Keynesians?

I don’t see the gold standard or liquidation to be intrinsic to the ABCT. The former is a tool to prevent the boom. The latter is a tool to clear out the detritus after the bust. I think there is room for ABCT for people to be irrational during the bust due to expensive money, just as there is room in the boom for irrationality (errors) due to cheap money. But again, I’m not an expert.

24 Barkley Rosser April 9, 2010 at 10:29 am


Of course there is also tax cut, tax cut, tax cut!


The gold standard restrains booms? Did it do so in the 1880s and the 1920s, major booms followed by severe busts?

25 Lord April 9, 2010 at 1:43 pm

Such is the muddled mess of Austrianism that even its supporters cannot figure out what it means.

26 Fully Certified Pussy Hound April 9, 2010 at 8:15 pm

Pete Boettke is so upset about all of this that he’s wolfed down not one, not two, but THREE boxes of twinkies.

27 indianajim April 10, 2010 at 12:57 am


Over aggregation is a problem that even someone as smart as you are can’t address without self-contradiction. There are links to some things that Robert Higgs has written that I think might be worth a look:

Along these lines and Austrian lines, I think that cuts in many aspects of government and government spending would be growth enhancing. Certainly the regulatory maze that Higgs exposes is a drag on growth. Price ceilings, floors, supports, quotas, import restrictions, etc. are creating deadweight losses massively. I’m surprised anything gets done in this country with all the roadblocks our government has constructed.

28 Greg Ransom April 10, 2010 at 9:50 am

Tyler, you’re talking crap again — and proving again you are no competent authority on Hayek’s trade cycle work.

It’s appalling that you continue to mislead your readers in this way.

29 Balsac, the Jaws of Death April 10, 2010 at 11:48 am

Who gives two shits what Robert Vienneau thinks about anything?

30 Lust in Space April 10, 2010 at 11:53 am

Anyone know where I can get a good pair of Uggs?

31 Robert April 10, 2010 at 1:41 pm

I thank my fans for their comments. For what it’s worth, Greg does have a letter to the editor published in The New Republic. I happen to have a letter published in National Review.

32 Greg Ransom April 10, 2010 at 2:50 pm

More proof you are talking crap when you mislead your readers with the false pretence that you are explicating Hayek. Hayek doesn’t claim these are necessary assumptions, and presents causal accounts of the cycle without these assumtions:

“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.”

You are poluting the public intellectual square, Tyler.

33 Diarrhea of a Madman April 10, 2010 at 3:21 pm

Greg knows a thing or two about polluting the public intellectual square; he’s kinda like an old drunk who must
wear diapers because he doesn’t know he’s pissing himself as he launches into (yet another) diatribe.

34 fundamentalist April 12, 2010 at 10:13 am

ABCT often begins with the assumption of full employment because, as Hayek wrote, that is where equilibrium ends. All analysis should begin with a state of equilibrium. But then hayek wrote “Profits, Interest and Investment” ten years later because of criticism for beginning with full employement. I think PII is a much better explanation of Hayek’s version of ABCT and it begins with high unemployment during the depression.

Anyone who thinks Sraffa, Kaldo, Cown or Krugrman are good critics of the ABCT simply don’t know the ABCT. And that is obvious from the comments.

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