The View From 1776
Thursday, November 04, 2010
The Business Cycle: Krugman vs. Austrian Economic Theory
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.