The Keynesian hangover

By Dennis Rice
web posted February 1999

The past couple of years of seen some serious problems cropping up in the world's economy, first with Asia, then with Russia, and now with Brazil. While there is still plenty of room for debate as to when the slowdown will hit North America and Europe, the question remains: what do we do when the present boom comes to an end? Recessions have occurred many times in the past and there is no reason to expect that this will not be the case again sometime in the future. Essentially, the choice that faces us is whether to deal with a recession by means of laissez-faire, free market policies, or have the state intervene to resolve what are alleged to be defects in the market.

One of the more well-known proponents of the interventionist approach to recession is Massachusetts Institute of Technology economics professor Paul Krugman. Professor Krugman has gained some notice as of late with his advice for the Asian economies, and in the December issue of Slate he expands on what are typically Keynesian proposals for dealing with economic downturns. If nothing else, his article offers fascinating insights into the workings of the Keynesian mind.

Krugman's article focuses on what he calls "the hangover theory", as popularized by economists of the Austrian School like Friedrich Hayek and Ludwig Von Mises. According to Krugman, the hangover theory essentially states that an economic boom must be paid for with a painful period of a slump "whose depth is in proportion to the previous excesses."

Krugman is somewhat vague as to what might cause the boom, but it results in "...the creation of too much capacity..." and "...an excess demand for money...". Krugman does not see why these factors should cause widespread chaos, however. He asks, "Why should the ups and downs of investment demand lead to ups and downs in the economy as a whole?" He goes on to lay out his solution to recessions: "...if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money?" The implication of these thoughts are clear: If you want to fight off a recession, an austerity program of spending cuts and tight money is the last thing governments should institute. According to Krugman, "...what the economy really needs is to take the easy way out."

Krugman's recipe is indeed simple enough. If the investment side of an economy has turned from boom to bust, then all that needs to be done is to shift emphasis to the consumption side, and a recession would be averted. Since the Austrian school and other proponents of laissez faire cannot bring themselves to accept the government spending and credit creation necessary for this to occur, Krugman believes they are stuck with accepting the misery of mass unemployment as a cure for recessions.

Krugman makes a case that is just as seductive as he claims the hangover theory to be. However, his argument consists largely of attacking a straw man. A proper understanding of the causes of recessions would begin with an examination of the role of today's politically-directed central bank system. In contrast to a banking system founded on free market principles, modern central banks excel at little else but the creation of fiat currency, that is, currency unbacked by anything other than a political promise. From time to time, as in the 1920's or today, the creation of fiat currency gets out of control.

Pressured by political interests for cheap credit, central banks begin extending credit at lower interest rates than a free market banking system would otherwise provide. With the economy snorting the financial equivalent of amphetamines, the boom phase takes off. The problem is not that excessive investment takes place during the boom, but rather malinvestment. The economy becomes riddled with enterprises that have no long term sustainability or markets for their products. Easy credit effectively lowers the risk premium on the use of capital such that people become less and less cautious about where their money is going. Given enough time portions of the economy take on the aura of a drunken party.

At some point, this boom must come to an end. It may be due to politicians realizing the excesses they have encouraged, or a currency that suddenly plunges in value, or a general lack of confidence in the banking system's ability to guarantee the safety of deposits. Whatever the catalyst, credit suddenly becomes much more expensive as people cut back on spending and investment and withdraw money deposits from financial institutions. Battered by this lack of confidence, the economy slips into recession, or, in extreme cases, a depression.

It is not that Professor Krugman doesn't admit that all the bad investments and bad loans undertaken during the boom created serious problems. But this does not worry the Professor, for he has an astonishingly simple solution: "Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?" This last statement is particularly instructive: it implies that bad investments should have no consequences. Writing them off can and should be nearly painless. The state can achieve this with a post-boom spending program financed with a new flush of fiat currency. This will allow individuals to forget the mistakes of the past and forge ahead to a dynamic, recession-free future.

The problem with such a "simple" solution is that if you establish a precedent whereby bad investments and bad loans can vanish with a few keystrokes, the next gush of easy credit will be used to finance even more bad loans and bad investments. People will become positively accustomed to abandoning all caution when investing. If this is repeated often enough, the economy becomes so overloaded with ill-considered schemes that the end result is the collapse in confidence in currency as such, with the consequent destruction of the division of labour. Eventually a crude barter economy will replace the previous one based on money exchange.

Professor Krugman's major mistake is to ignore the fact that one cannot manufacture capital with a printing press. Capital must be created by someone, by some means. It requires a process of mental effort that cannot be replicated by governmental decree. If that capital is wasted on a venture that has no future, it must be painstakingly rebuilt. The worst course of action a government could take would be to create conditions under which capital is thrown away not just once, but over and over and over again through massive inflation of the currency. Faced with the continual decline in the purchasing power of money, capitalists would realize that their hard work is utterly pointless and withdraw their creative energies from the economy. That would create a problem far greater than the unemployment of workers: the unemployment of capitalists, without whose productive ability gainful employment would not be possible for anyone at all.

Another related mistake of Krugman's lies in his advice to offset the burst investment bubble with a state-sponsored consumption boom. This ignores the fact that the prolifigate central bank credit that causes the initial investment boom also stimulates a consumption boom. Personal indebtedness typically soars under such circumstances and savings rates plunge as individuals take advantage of easy credit to finance the purchase of items like automobiles, housing, vacations and so on which represent consumption, not investment. Since government projects and spending programs typically produce no return on investment either, they too can only be termed further consumption of what is by now extremely scarce capital. To talk about remedying the effects of rampant consumption by encouraging even more consumption amounts to trying to eat one's vegetable garden without actually having grown it first! Such a course of action does nothing to "fix" recessions, it only prolongs them.

The best approach a government can take when faced with an impending recession is to frankly do the opposite of the standard Keynesian approach. The first step is to resist the temptation to stall the inevitable liquidation of malinvestments, so as not to drag out the pain. Attempting massive bailouts of failing enterprises, cartelization of industry and the imposition of trade restrictions would be a huge mistake. Other interventionist strategies like saddling the economy with pro-union labour legislation and controls would only drive up wage costs. The resulting decrease in business profitability would cause even more bankruptcies and hence greater unemployment. In fact, this kind of intervention, not a laissez-faire attitude, is what ensured that productive capacity was left idle for significant lengths of time in periods like the 1930's.

Contrary to the thoughts of Krugman and other Keynesians like him, the fundamental requirement of economic growth is freedom; the freedom to be productive. Since consumption cannot take place in the absence of investment, a failed malinvestment boom can only be remedied with another investment boom, but this time with one based on a sound banking system and a liberalized, deregulated economy. Government spending should be slashed rather than accelerated. This would free up capital for uses that are actually productive and which add to the division of labour, thus increasing productivity and living standards. In the absence of politically-spurred credit creation, malinvestments would be noticed and corrected before they infect large segments of the economy. Foreign investment will flow in as long as investors are assured that they will not be wiped out by regulations like exchange controls. The end result would be a quick resurgence in employment levels. Perhaps such prescriptions could not be considered "easy", but then neither are Krugman's. His solutions merely appear easy because their full implications have not been carefully considered.

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