Paul Krugman on Austrian trade cycle theory

Here’s the problem: As a matter of simple arithmetic, total spending in
the economy is necessarily equal to total income (every sale is also a
purchase, and vice versa). So if people decide to spend less on
investment goods, doesn’t that mean that they must be deciding to spend
more on consumption goods–implying that an investment slump should
always be accompanied by a corresponding consumption boom? And if so
why should there be a rise in unemployment?

Here is the link once again.  But I think the point is more effective in reverse.  Why should the boom be a boom in the first place?  The shift toward investment goods, and thus away from consumption goods production, should mean falling real wages, not rising real wages.  In other words, the Austrian theory doesn’t generate the very high degree of comovement found in the data.  Or, in other words, there aren’t that many countercyclical assets.

One MR commentator suggests this, this, and this as responses.  They make various points against Krugman (who I might add is not as clear as usual in this piece) but they don’t solve this central problem of generating the amount of comovement found in the data.  The best shot is to relax the Austrian-favored methodological assumption of full employment; I leave it as an exercise for the reader whether that could work and what other problems for the theory it might create. 

I should add that Gordon Tullock has made much the same point, as has Bob Lucas or for that matter Piero Sraffa in 1932.


The short answer would be : malinvestment, not overinvestment. In ABCT, the two ways this operates are :
- inflation changes relative prices and the resulting price signals cause entrepreneurs to misinterpret consumer preferences;
- inflation introduces noise in interest rates and causes intertemporal discoordination.

Would this imply that C and I are negatively correlated?

Also, I wonder how stable the separation line is between investment and consumption goods. This makes statistics tricky to interpret.

I'm not sure I follow his logic that spending is necessarily equal to income. Equality goes both ways, so by this logic every dollar earned is spent; is there no option for saving?

It's not obvious to me why a reduction in investment necessarily would lead to an increase in consumption. What if, instead of investing their dollars, people simply stuffed dollars in mattresses?

ABCT is a matter of increased discoordination through time. Equilibrium interest rates coordinate the intertemporal plans of households with business investment plans. Although we never have equilibrium in credit markets, in the strict sense, variations in the nominal quantity of money can increase discordination in the market for loanable funds, and result in a boom-bust cycle. With monetary expansion households and businesses aim at mutually inconsistent plans, given scarcity constraints. Inflation reveals the inconsistency of these plans over time, and the expansion ends. This is a very reasonable argument that stems from plausible assumptions regarding the informational function of prices.

Many economists have put "full employment" to be an economy experiencing a 5.5% or 6.0% unemployment rate. Now imagine a production possibility frontier with consumption on the horizontal axis and future consumption or investment on the vertical axis. Next, the Fed increases the supply of money and credit that creates more economic activity, which lowers the unemployment rate to 3% or 4%. This level of full employment is a possible but unsustainable. There is a movement off the sustainable production possibility frontier in the north east direction, i.e. an increase in both consumption and investment. However, this increase in both consumption and investment is not sustainable and must eventually collapses. The credit expansion has put resources in to use that would not otherwise have been put in to use (for example, a lower interest rate cause projects that may have had a negative NPV before to now have a positive NPV) causing an increase in both investment and consumption; and wages rise across the board. The credit expansion has increased consumption and investment and also real wages for workers engaged in investment and consumption production.

For the life of me, I could swear some GMU blogger was suggesting that Krugman was arguing for the tenets of the ABC without calling it the ABC. Not your post in April, but before that. I'm still trying to dig it up.

But I always thought the argument was similar to what Gu Si Fang is making. Namely that the change in inflation causes the interest rate to go from say 4% to 2%, thus making a project that's profitable at 3% now look worthwhile. Thus investors will invest in it, but when consumers adapt to the change in inflation the rate will change back from 2% to 4% and now this project will be generating -1% and all projects under 4% that were invested in will go bust.

It's been a long time since I read Mises, but why the investment/consumption either-or? I don't recall that being a part of the theory. And does investment not fuel consumption? You can't build houses everywhere without going to Home Depot. I thought the Austrians explained that it was time preference that changes, investment simply being deferred consumption.

My understanding is similar to Gu Si Fang's. Risky projects that would not normally appear profitable become "feasible" at an artifically low cost of money.

Unless I'm missing something, in a downturn C+I falls, thus Y falls, and Tyler's positing that Y must hold stable so change in C must equal change in I?

I'd say that we can posit savings, so that C and I are both deferred to the future, thus Yt can fall.

Krugman: So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom?

No. A flight to safety, or to cash, is a sudden shift in time preference. Selling your tulip bulbs and stashing the money is not going to increase consumption.

The best that von Hayek or Schumpeter could come up with was the vague suggestion that unemployment was a frictional problem created as the economy transferred workers from a bloated investment goods sector back to the production of consumer goods. (Hence their opposition to any attempt to increase demand: This would leave "part of the work of depression undone," since mass unemployment was part of the process of "adapting the structure of production.") But in that case, why doesn't the investment boom—which presumably requires a transfer of workers in the opposite direction—also generate mass unemployment?

Um, maybe because the boom happens over an extended period of time and the crash happens quickly, faster than labor and capital markets can adjust?

And anyway, this story bears little resemblance to what actually happens in a recession, when every industry—not just the investment sector—normally contracts.

I you accept this then it is impossible to talk about a recession "led by" housing, or some other sector of the economy. If the investment/consumption dichotomy is false, then this is false. Was Schumpeter really "vague?"

David Peterson is referring to this post in which Alex points out that a number of non-Austrians cited Fed-induced credit expansion as a cause of the current bust.

Here is the BCT I got from Devil Takes the Hindmost. Investors are perpetually searching for greater "yield" especially if interest rates are low. Some investment seems to provide greater yield e.g. MBSs. There is greater and greater demand for the asset. The asset increases in value. The asset itself is used as collateral to create credit which is in turn used to buy more of the asset which creates a positive feedback loop. More and more people start buying the asset and eventually its value is determined purely by speculation. The bubble bursts and the asset starts going down in value. People start selling to cover their loans, asset values decrease, credit drys up and a positive feedback loop begins in the opposite direction.

Its pretty clear from the history of speculation that in a speculative boom a large number of people know that the investments don't make any sense and that there will be a crash. They all hope they can cash out before the crash. Speculative booms basically are very similar to pyramid schemes.

As is his wont, Tyler once again airily alleges a grave flaw in the ABCT without evincing acquaintance with the barest rudiments of the theory. The ABCT is a malinvestment theory, not an overinvestment theory as Tyler's post implies. Forced saving does not result in investment, but in the production of wasted capital assets. Concurrently, the creation of fiduciary media and the distortion of interest rates that feed the boom and forced saving cause the falsification of economic calculation that also misleads those involved in the production process into overestimating their incomes. Most spend part of these illusory gains on raising their standard of living in the present, setting up a general and pronounced tendency to overconsumption. Thus overconsumption, not overininvestment, is the obverse of forced saving and the essence of the boom

Mises (HA, pp. 555-56)was quite clear on this point: "The ensuing boom in the prices of producers' goods may at the beginning outrun the rise in the prices of consumers' goods. . . . But with the further progress of the expansionist movement the rise in the prices of the consumer goods will outstrip the rise in the prices of the producers' goods. The rises in wages and salaries and the additional gains of the capitalists, entrepreneurs, and farmers,although a great part of them is merely apparent, intensify the demand for consumers' goods. . . . It is customary to describe the boom as overinvestment. However, additional investment is only possible to the extent that there is an additional supply of capital goods available. As, apart from forced saving, the boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment."

Thus not only does ABCT explain the requisite "comovements in the data," it demonstrates the indissoluble link between forced saving and overconsumption. Before Tyler delivers himself of anymore breezy apercus concerning ABCT, he should write 100 times, "Overconsumption not overinvestment."

Oh no Tyler, I'd say you just got PWNED by cleric. I find myself wondering why people like you and Krugman even bother to criticize ABCT given that you don't seem to have devoted enough time to understanding what it actually says.

1) Until I chanced upon this site last December (2007), I knew little about Austrian economics except for the work of Joseph Schumpeter . . . and especially his thoughtful revision of Kondratieff long-term business cycles --- long term waves in Schumpeter’s terminology --- that related those 50 to 60 year cyclical fluctuations in economic growth, including major recessions, to clusters of revolutionary technologies that burst onto an industrial economy every several decades.

On the Schumpeterian view, these radically restructuring technologies are implanted and eventually diffused through certain advanced industrial economies --- and later, depending on the speed of change (itself a technological outcome), all around the global economy --- thanks to the raw animal spirits of bold, risk-taking entrepreneurs. To succeed in the market-place, these adventurous entrepreneurs manage to attract capital and skilled labor of various kinds in a process that Schumpeter eventually called “creative destruction†.


Meaning that the bolder, more imaginative entrepreneurs are able to bring the products of these new technologies to the market-place; able to find the necessary capital to begin and later expand their new business enterprises --- able also to find and attract talented labor at all levels ---- and in these ways, over time, grow into giant firms eventually by means of creative destruction. Necessarily, then --- for creative destruction to work and free capital and labor this way --- old, increasingly standardized industries have to decline in the pioneering technological countries. Their wage-levels and the marginal product of capital invested in them, to clarify this point, make the old established firms increasingly uncompetitive with the competitive firms and industries in lower-wage, less capital-intensive economies that have acquired the no-longer revolutionary technologies by a variety of means --- licensing, multinational transfers, pirating, and so on. Without such decline --- which government shouldn’t interfere with, despite the clamor of special interests like trade unions or managers and owners trying to "bribe" politicians --- the necessary capital and talent and hence market expansion for the newer entrepreneurially created firms wouldn't be able to grow.

And sooner or later, to use a concept coined by Solow after Schumpeter's death, the advanced national economies that refuse to let creative destruction work will find their growth rates of productivity and GDP per capita dwindle off into a "steady state" of low growth in each.


2) Enter a couple of key confusions in my baffled mind about Austrian business-cycle theory (or theories) besides Schumpeter’s long-wave approach . . . which is obviously not what Tyler means by the theory, nor, come to that, any of the three links he listed besides the one to Krugman’s criticisms. And possibly, a plea here, for some of the posters to help dispel my bafflement.

To wit:

(i.) Whatever else might separate Schumpeter’s focus on long-term cycles and technologies ---which resemble in a way real business cycle theory, focused of course on short-term fluctuations in economic activity around the long-term growth trends of productivity and GDP growth --- don’t all Austrian economists share in common a suspicion of neo-classical equilibrium notions and postulate that a capitalist economy is a constantly unstable dynamic process of change?

(ii.) And don’t all the Austrian economists except Schumpeter find that the main problem in modern business fluctuations --- whether boom-times or recessions --- can be traced back to the abandonment of the gold standard and the creation of fiat-money (and inflationary expansions) in the period of central banks and fractional-reserve banking?


3) You grasp the causes of my baffled mind here, I trust. Specifically, how are propositions (i) and (ii) reconcilable?

Because, you see . . . if (ii) is right, then booms-and-recessions wouldn’t occur in a capitalist economy, would they?

And doesn’t that mean there would be a tendency now some equilibrium and hence fully predictable path of long-term economic growth for an economy’s productivity and GDP? In particular, to clarify my problem here, wouldn’t a capitalist economy on a gold standard and no central bank or fractional-reserve banking tend to that long-term growth-trend set by the “natural rate of interest† --- a concept taken by the Austrians, I believe, from Wicksell -- thanks to an equilibrium in the loanable funds market between the supply and demand for savings (capital) that’s is no longer screwed up by fiat money? There would then, n’est-ce pas? be no huge misallocation of capital investment in any boom phase --- in fact, no boom phase at all, right? --- and hence, by extension, no subsequent recession as a corrective measure, yes?


But wait!

How then can these two-related equilibrium postulates --- implicit, it seems, in (ii) and relating to an equilibrium in capital markets and hence in long-term steady growths in productivity and GDP without noticeable fluctuations --- be reconciled with postulate (i)’s stress on the ever changing, dynamic, and hence unpredictable nature of the growth rates of long-term productivity and GDP that require fully unforeseen, raw entrepreneurial breakthroughs to keep the marginal product of capital from falling to zero and an economy ending up in the Solow 'steady state?"


4) As I say, I am very much a half-wit amateur when it comes to Austrian business cycle theory (leaving aside Schumpeter’s very different approach from its mainstream theorists). Yep, call me a dunce if you want . . . at any rate, as thing now stand. So any help in dispelling my dunce-like confusion here would be very much appreciated.


Michael Gordon, AKA, the buggy professor

Dear buggy one,

I find your confusions quite understandable.

The initial confusion is a common one, which is that because Schumpeter was an economist from Austria he must be an Austrian economist. In fact he is at best a distant cousin of the Austrian School of Ludwig von Mises, to whose theories you refer. Mises and Schumpeter also share the fact that they were narrative, rather than mathemalotrous, economists - in other words, their methodology was not inherently quack.

But Schumpeter is still basically a quack. In particular, his theory that innovation shocks and "creative destruction" are the cause of the business cycle is not the ABCT and should not be confused with it. While it's certainly true that creative destruction happens (in our time, the rise and fall of "Route 128" is a fine example), it is simply implausible that it's the cause of the banking panics that have plagued the Anglo-American world for at least the last two centuries.

What financial crises did the Apple II cause? Was Intel's new 80386 chip responsible for the crash of 1987? It's preposterous on the face.

You surmise correctly that an environment of Misesian banking is an environment of stable prices, whose movements if any are the result of basically Schumpeterian or Talebian (Taleban?) uncertainties and discoveries. Correlations between unrelated asset and commodity prices, in particular, should be particularly unusual. To gain by trading, you have to know more than the other traders. The Austrians are not the only people who understand this, although so far as I know they have the only design for a world in which it pertains.

The concepts of "productivity" and "GDP" to which you refer are meaningless aggregates, characteristic of the economic planning apparatus of the 20th century. Imagine living in a Stalinist country which produced a data series called "gross national happiness." "Comrades! The NBER has shown that you are over 3% happier this year!" Headline aggregates such as GDP and CPI, though slightly more sophisticated than this, are still basically propaganda instruments. Please do free yourself, O buggy one, of these officious delusions.

In general, you seem to be in the grips of the theory that financial instability is actually the price we pay for progress. But there is a qualitative distinction between the obsolescence of the minicomputer industry and, say, the crash of 1929. You cannot advance to the next level of the temple, and grapple with the ABCT itself (for the beginning student of Austrian economics, it is best to stick with the original black belts - Mises and Rothbard only), until you accept this distinction.

Waves in the real world will always cause the financial industry to bob and rock. Giant unexpected rogue waves of death, perhaps, could cause it to sink. All of Asia could be fried tonight by a gamma-ray burst in Sagittarius. Surely, even in the Austrian utopia, this would cause a number of banks to fail. What the ABCT tells us, however, is that Lombard Street banking is generating its own waves - which is something totally different.

Dear buggy one,

Please try reading the Misesian explanation of the business cycle I linked to earlier, and if necessary the longer discussion of maturity transformation linked from it.

You can also go here to watch me discussing the subject with an actual banker - or at least, someone who does a very good banker impression.

Basically, what Mises identified - through a priori deduction - is an engineering failure in our present banking system that can create its own shocks. It is much more difficult to prove that any particular crisis is the result of a maturity crisis, although the fluctuation in the yield curve is fairly telltale.

But, for example, there is no way to distinguish high default risk (insolvency) from high yield (illiquidity) in the extremely low prices of mortgage-backed securities today. From a financial perspective, perhaps the same observations could be produced by a gigantic infestation of termites. All I know is that I see no newspaper articles about termites, and a lot about bank failures. But this is hardly conclusive in any kind of scientific sense.

Mencius, how does your explanation account for the business cycles that don't involve bank runs (i.e. most of them)?

daneli, the yield curves that exist in the real world today have very little to do with any Austrian free-market abstraction. Short rates are set by the Fed and long rates are set by the Chinese.

The reason flat yield curves are related to recessions is that every time the Fed tries to raise short rates to a level above "free money for everyone," the financial system goes kaplooie.

Bill, the "Austrian" free bankers are crackers. You can't suspend payment and still have your notes trade at par without some kind of government protection. Usually implicit, but still present. All the so-called "free banking" systems of the past (Scotland, US state banks) had big friends in power.

My two cents:
1) The Krugman/Cowen criticism, even if assumed to be correct, does not disprove the whole of the Austrian Theory of the Business Cycle. To use the standard Lakatos terminology, it is an attack on a (presumed) auxiliary hypothesis, not the core.
2) As others have pointed out, neither Mises nor Hayek assumed full employment or made it a major element of their theory of the business cycle. It is a typical keynesian misrepresentation of an opposing theory -Krugman would surely contend that Austrians work on the implicit assumption of full employment, but then Keynesian economics works under the implicit assumption that economics is only a "spending problem" unless we are in "full employment", which they consider to be chimeric and the position systematically attributed to opposing views.
3) The criticism is flawed. Resources are not given under an Austrian point of view. Economic resources that were not profitable to mobilize (both human and material) become apparently profitable when the interest rate is artifically lowered. Why were they not profitable? Because the calculated value added from them was negative -mobilizing them would come at the cost of destroying capital. Why do they seem profitable with a lower interest rate? Because capital seems less scarce than it actually is thanks to the newly created money or credit out of thin air. New resources are mobilized, higher wages are paid, more is produced, because people do not realize that they are paid with devalued money. (Consumption, investment and income moving together in the boom). This comes at the cost of wasting capital, of destroying it in the process of paying for the new resources that had to be mobilized. But few agents realize that capital is being lost. Accounting registers increased monetary profits, not the erosion of the capital base in "real terms", because the purchasing power of money (which goes well beyond the CPI) is hard to measure. Once they do realize that the investments are not profitable (either because of a change in inflation perceptions or because of the popping of a price bubble), then comes the horror at the reckoning of the erosion of the real capital. Then comes a painful process of readjustment of resources. Every cycle has its particularities, but in this cycle it was an asset boom in housing, and the erosion of the capital base has been all too evident in the banking sector.

All of it consistent with both the Austrian theory and the stylized fact mentioned by Krugman and Cowen. No need to call in irrationality, just the difficulty in real life of calculating value (the Mises calculation thesis) and of coordinating resources (the Hayekian view).

More to the point of this post:

Here's an attempt at generating comovement from overinvestment. On a micro scale if a business overallocates to capital expenditures its operations budget must suffer. Unless the business has access to sufficient financial capital to fund the expanded operations it must adjust and accept some losses. Such adjustments and even the squeezed operations budget itself feel like sources of strain on employment.

Krugman it openly admits he doesn't have the patients to read "prose" economics written by economists of Friedrich Hayek's generation.

It's more than clear that Krugman has never read Hayek.

I have my doubts that Tyler has carefully read it either -- very, very serious doubts.

If he's read it, he didn't understand it.

Krugman writes:

"So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom?"

This is both idiotic and has an obvious answer, if you've read Hayek, which Krugman hasn't.

The economy has very many different paths of investment, closer and further from direct consumption. "Investment booms" typically push the "time" structure of the economy into investment goods farther from consumption.

When the crisis comes, what is happening is that all plans don't cohere -- there's a failure of the coordination of plans across time. Not enough resources were devoted to investment in production for consumption close at hand in terms of time. There is TOO MUCH consumption at "both ends of the stick" -- both consumption for the production of investment goods far from immediate production, and more immediate consumption and production for consumption. The system can't produce what people have planned to consume because their plans were for more consumption than the distorted production system can possible produce, with the built in mismatch of plans across time in the structure of production.

Dis-coordination causes people to lose their jobs in oversupplied investment goods far from immediate consumption. And a failure to correctly plan leave production for more immediate consumption to be under supplied, and under invested.

But enough

What Krugman and Tyler need to do is their Freshman homework when it comes to Hayek

If you are going to attack the economics, you should know it.

Which Krugman and Tyler clearly don't.

If I recall my Hayek, Hayek is suggesting that there is capital consumption -- there's not much shift away from consumption goods production, there is over consumption and over investment everywhere. And folks only down the road see that their plans don't coordinate over time in terms of production and consumption plans. They end up not being able to finish their production plans, and they aren't able to consume as much as they had anticipated. And they are LESS WELL OFF than they otherwise would have been. They've consumed capital they wouldn't have consumed if they'd coordinated their plans successfully over time

Get it?

Tyler wrote:

"Why should the boom be a boom in the first place? The shift toward investment goods, and thus away from consumption goods production, should mean falling real wages, not rising real wages."

I've long doubted that Tyler actually read much of Hayek's work on this matter.

And I still doubt it.

"The best shot is to relax the Austrian-favored methodological assumption of full employment .."

You mean like Hayek did in 1937?

Very grateful to a bunch of much better skills. I look forward to reading more of the future of the subject. Keep the good work。thanks!

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