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The business cycle: Krugman vs. Austrian economic theory

By Thomas E. Brewton
web posted November 8, 2010

The Keynesian black-box doesn't work, because the reality of independent actions by millions of individuals is ignored in order to achieve a simplistic representation of the economy in computer models.

Keynesian economics, as expounded by New York Times columnist Paul Krugman, is essentially a black box theory.  Stand on the outside of the economic box and dump into it endless baskets of inflationary fiat money, and things supposedly just happen automatically inside the black box to produce permanent prosperity and near zero unemployment. 

Read David Gordon's commentary on The Hangover Theory by Paul Krugman.

Keynesians gloss over the human factors of uncertainty about keeping a job or losing a home, millions of different consumer preferences, and the chilling effect on businessmen of punitive government taxes and regulations, along with continual threats of more of the same.  Keynes's feeble gesture in that direction was allowing that "animal spirits," a kind of gambling instinct, played some role in businessmen's decision processes. 

From the Keynesian perspective, businessmen don't make rational decisions.  They, like the rest of the public, don't know what is best for them.  As with Pavlov's dogs, they are expected to exhibit a conditioned response to the stimuli administered by intellectual theorists.

Paul Krugman's simplistic view of the economy, among other things, ignores the fact that government stimulus handouts usually are targeted by Congress to favored special-interest groups.  Most people without jobs and in danger of losing their homes will never receive a dime of the stimulus funds.  Private businesses, the engines of the economy, are not among the favored interest groups.

Keynesian theory ignores the fact that money is not real wealth.  Economic well being and improved living conditions can come only from increased production of goods and services that people freely choose.  Phony money earmarked for green jobs, wastefully expensive battery-powered automobiles, and environmental scams such as ethanol won't cut it.  Keynes himself set the tone, asserting that government expenditures on anything would rejuvenate the economy.  His suggestion: pay men to bury fiat paper money in bottles and pay other men to find the bottles and dig them up.

Increasing production, when businessmen perceive possibilities for profit in doing so, is the only real source of income for consumers.  Moreover, increased business payments to suppliers and workers is non-inflationary, because the volume of available goods and services rises as incomes increase.  Government stimulus spending is inflationary, because the money supply increases long before production increases.

If one takes Keynes literally, inflation is a good thing.  Think of Federal Reserve chairman Ben Bernanke's assertion that the Fed seeks to promote inflation at approximately a 2% annual rate.  Add to it the forthcoming QE2, designed to raise the rate of inflation. 

Keynes acknowledged that deficit spending with fiat money, created by bookkeeping entries at the Federal Reserve banks, would have inflationary consequences.  But, he opined, workers and others wouldn't notice its effects in the short run.  Having more fiat money via government handouts, with no increase in actual production of goods and services, would fool the public.  Believing that prosperity had returned, people would stop saving and paying down debt and would add to their debts to resume consumption spending at the pre-recession rate.

Consumer spending is touted by Keynesians as the be-all and end-all.  In their paradigm, spending on consumer goods alone has the economic pulling power to gain what Paul Krugman calls "traction."  Yes, consumer spending is about two thirds of cash flow in the economy, but only if you view it as an application of funds.  The underlying source of all that consumer spending is business production that necessitates payments to suppliers of materials and wages to workers.

Stimulus payments to consumers is analogous to dumping frosting onto a cake mix, before the ingredients have been mixed and baked.  All elements of the economy, from raw materials, to intermediate goods, to consumer goods, must return to a supply-demand balance before the economy can gain Krugman's "traction."  That necessarily takes time, because mining companies and other producers of basic raw materials have time scales for increased output and employment that are very different from the time scales of intermediate goods producers and consumer goods manufacturers.

Deficit spending, ballooning Federal debt, and a Fed dumping money, along with the prospect of higher taxes and unknowable impacts of multifarious new regulations, breeds fear among business decision makers that impedes the re-balancing process.  In the 1930s, such actions under Herbert Hoover and Franklin Roosevelt prolonged what should have been a two-year recession into twelve years of Depression misery.  President Obama's similar Keynesian policies are repeating the Depression mistakes, giving us a flattened economy, with unemployment projected to remain in the 9% (really 17%) range for several more years.

Despite Paul Krugman's assertions, Austrian economists don't advocate higher unemployment and deflation, nor do they want to punish credit profligacy. 

They simply want to eliminate the Federal Reserve's ability to fund speculative booms with excessive easy money (low interest rates).  Since the end of World War I, shortly after the Federal Reserve came into being, every inflationary boom and recession has been preceded by the Fed's pumping excessive reserves into the banking system.

Artificially easy money and low interest rates lead businessmen and consumers to believe that there is unlimited demand for products of the latest bubble element of the economy.  Without excessive money creation, from 1987 onwards, there would have been no dot.com boom-and-bust, and no housing bubble that corrupted the banking system.

Rather than unemployment, as Paul Krugman apparently believes, Austrians advocate price flexibility, including wages.  It is labor unions and their government supporters who indirectly promote higher unemployment.

Before the New Deal's 1935 Wagner Act gave labor unions power to bludgeon employers, businesses were able to minimize layoffs by temporarily reducing wages to bring their costs into line with their reduced selling prices for goods.  Better for all workers to have lower pay temporarily than for many of them to lose their jobs.  Wage reductions spread the hit over the entire work force.

In the Depression, labor unions, with the full weight of the Federal government behind them, demanded higher wages in the face of high double-digit unemployment.  To compensate, huge numbers of non-union labor had to be laid off, leaving them, not with lower wages, but with no wages at all.  Our parents and grandparents paid for the extortionate power of labor unions with lowered living standards.

We see a repeat of this Marxist class warfare today in New York, California, and other strongholds of the Democrat/Socialist Party.  Public employee unions not only are unwilling to consider reductions in their gold-plated benefits packages to avert state bankruptcy.  They demand new wage and benefit raises at a time of high unemployment and skyrocketing taxes for everyone else.  Labor unions thus block job creation.

With regard to deflation, which Krugman ascribes to Austrians' wish list, most prices naturally decline (unless artificially propped up by the government) when demand lessens or supply increases.  Demand lessens when big-employment industries like housing construction overbuild, and buyers no longer can support their bloated personal debt.  Demand lessens further when a bubble-bust causes banks to tighten credit for everyone, while they liquidate over-valued collateral on defaulted loans to bring balance sheet ratios back into line with regulatory requirements.  Prices are bound to decline (deflation to some extent, in some sectors of the economy) when excessive inventories (housing, for example) are dumped into the market by lenders.

Analogously, people have garage sales when they have accumulated too many things or things that they no longer need.  Nobody in his right mind would expect buyers to pay original retail prices.  If garage sellers want to clear out their stuff, they have to cut prices, often to a small fraction of original prices.  That's deflation, yes, but it gets rid of the excess, puts some money into sellers' pockets, and opens space for new purchases.

Austrians don't advocate deflation.  They seek to forestall speculative bubbles that lead to deflationary recessions.

Austrians note the statistical fact, in every economic recession since the Fed's legislative enactment in 1913, that financial bubbles and recessions have followed over-creation of money by the Fed and its support for excessive credit expansion by the banking industry.  Those bubbles are accompanied by price run-ups unsupported by underlying, long-term real demand.  They also note that long-lasting, non-inflationary business upswings can occur only when the Fed buts out and businesses are allowed to sink or swim while liquidating excess inventories and over-built production facilities. 

Only under Fed chairman Paul Volcker in the early 1980s has the Fed followed that policy to deal with a recession.  The result was a severe downturn for nearly two years, followed by sharply reduced inflation and one of the longest and strongest economic revivals in history.  Had the Fed under Volcker's predecessors not flooded the economy with easy credit, the punishing rigors unleashed by Volcker would have been unnecessary. ESR

Thomas E. Brewton is a staff writer for the New Media Alliance, Inc. The New Media Alliance is a non-profit (501c3) national coalition of writers, journalists and grass-roots media outlets. His weblog is The View from 1776Z. Email comments to viewfrom1776@thomasbrewton.com.





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