Krugman and Austrians: the Depression Will Get Worse

While Austrians and Keynesians don’t agree on a lot of things, there is one thing upon which they both seem to agree: the U.S. economy is sinking into the morass of depression. At that point, however, the agreement ends, as the two schools have very different explanations as to why this is happening.

The Keynesians, through their Paul Krugman and the New York Times megaphone, have been claiming that the original Barack Obama “stimulus” was too little, and the current emphasis upon budget cutting at all levels of government is exactly the wrong strategy. Austrians, not surprisingly, believe that this explanation is nonsense, and dangerous nonsense.

In a recent column, Krugman lays out his thesis, and it is useful, for it truly exposes the Keynesian mind at work, and a Keynesian mind that allows for no other explanations as to what is happening. The problem is – and always will be – a lack of “aggregate demand,” and the only solution is for governments to spend as though they hit the jackpot.

He writes:

The great housing bubble of the last decade, which was both an American and a European phenomenon, was accompanied by a huge rise in household debt. When the bubble burst, home construction plunged, and so did consumer spending as debt-burdened families cut back.

Everything might still have been O.K. if other major economic players had stepped up their spending, filling the gap left by the housing plunge and the consumer pullback. But nobody did. In particular, cash-rich corporations see no reason to invest that cash in the face of weak consumer demand.

Nor did governments do much to help. Some governments — those of weaker nations in Europe, and state and local governments here — were actually forced to slash spending in the face of falling revenues. And the modest efforts of stronger governments — including, yes, the Obama stimulus plan — were, at best, barely enough to offset this forced austerity.

So we have depressed economies. What are policy makers proposing to do about it? Less than nothing.

If anything described the Keynesian mindset, it is this: Spend, spend, spend. It is a simple thesis, one that certainly appeals to politicians, and even to much of the general public, and has dominated professional economic thinking in the USA since World War II. As Krugman has stated above, households cannot spend what they don’t have, and businesses are not going to invest (read that, spend through capital investment – which always is defined by Keynesians as being valuable because of spending, not by aspects of capital productivity) because they don’t see future demand.

So, we are stuck in what Krugman and Keynesians call a “liquidity trap,” which Krugman seems to believe ends all other discussion. (The notion is that the Law of Opportunity Cost is suspended during a “liquidity trap” because interest rates are low, resources are “idle,” and government can borrow at near-zero percent and spend without consuming any resources. As Krugman said in his book, The Return of Depression Economics, government spending in this situation can create a “free lunch.” He actually used that term.)

While most mainstream economists are not willing to engage the Keynesians on the idea of the “liquidity trap,” Murray Rothbard did not back away. In his book, America’s Great Depression, he takes on the whole notion of the “liquidity trap” head on, writing:

The ultimate weapon in the Keynesian arsenal of explanations of depressions is the “liquidity trap.” This is not precisely a critique of the Mises theory, but it is the last line of Keynesian defense of their own inflationary “cures” for depression. Keynesians claim that “liquidity preference” (demand for money) may be so persistently high that the rate of interest could not fall low enough to stimulate investment sufficiently to raise the economy out of the depression.

Rothbard points out a serious problem with that analysis, noting that Keynes never got the theory of interest correct, claiming interest is based upon “’liquidity preference’ instead of time preference,” which then leads to more incorrect conclusions about the state of the economy. Other Austrians have criticized the theory, as well, including William Hutt and Henry Hazlitt.

Both Hutt and Hazlitt took on the whole idea of “idle resources,” which is behind the notion that opportunity cost can be suspended during a depression. The idea of “idle resources” is based upon a notion that factors of production are unemployed because of a lack of spending, and that a burst of government borrowing (at near-zero, which means almost no opportunity cost) will spread to these unemployed assets and put them back to work.

As I noted before, the Keynesian theory is disarmingly simple; resources are unemployed, so government “stimulates” the economy through more spending, the resources are put to work, and somehow, the economy magically sustains itself. On the flip side, Keynesians hold that if new spending does not occur, then deflation will result, making more resources unemployed until ultimately the economy is in a perverse equilibrium in which huge numbers of people are out of work with no prospects for economic improvement.

Krugman is adamant about this point and is so convinced of his rightness that anyone who might disagree does so only because that person wants to see people suffer or because that person is so beholden to the “discredited” Austrian theories that he or she is incapable of adding anything to the public debate. (In fact, Krugman believes there is no debate at all. His position is right, is proven empirically, and cannot be refuted – even when it is refuted.)

Thus, even though we have seen an explosion of government spending the past few years, according to Krugman, we really are on an “austerity” plan. Why? It is because if the government actually had increased spending on a massive scale, then we would be out of this depression. In other words, since there is only one way out of this morass, and since we are not out of that morass, there hasn’t been enough government spending.

What about the Robert Higgs thesis of “regime uncertainty”? Krugman dismisses that one, too, derisively calling it the “confidence fairy.” Businesses, he argues, are hoarding cash because they see a lack of consumer demand. If governments spend and spend and spend, then businesses will invest, period.

(As for the anti-business rhetoric pouring out from the White House, the surge in regulation, and the demonizing of the oil and coal industries – which are essential players if this economy is going to recover – all of that, according to Krugman, either is non-existent or just white noise, and it certainly has no relevance to our current situation. Why? Because Krugman says so.)

The ultimate answer, according to Krugman and the Keynesians, is to find yet another boom, another possible asset bubble that can work its “magic” at least for a while before it, too, collapses. (Perversely, in a post endorsed by Krugman, Karl Smith hopes that it will be another housing boom.

In reading Krugman and the Keynesians, I always am struck by their notion that assets, economically speaking, really are homogeneous. It doesn’t matter where new spending is directed, just as long as there is spending. Spend, and everything else falls into place.

Second, the Krugman/Keynesian viewpoint is based on an extremely mechanistic interpretation of human action. People within a market setting do not purchase goods they believe will meet their individual needs; no, they spend, as though the spending itself is the ultimate end of an economy.

This is a view that separates production and consumption, making them independent of one another with no true purposeful human action to be found anywhere. There is no meaningful connection between desires of consumers and the valuation of factors of production or the direction that factors go in the various lines of production. It all is something that simply can be described as Y = C + I + G with no need to think further than that tautology.

As I said at the beginning, both Austrians and Keynesians believe we are headed for a steeper economic downturn, perhaps into the abyss of a major depression. However, Krugman and the Keynesians believe that the only salvation is for massive spending and intervention by government. Austrians believe that it is the massive spending and intervention by government that makes things worse, and while Krugman and Company never will admit otherwise, it ultimately is the Austrian paradigm that explains these matters, and explains them with accuracy.