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Introduction to Austrian Economics
Podcast surveying the basic concepts of Austrian Economics.
The Keynesians’ Special Case
Or is it just capital malinvestment?
Some economists claim the economy is in a Keynesian liquidity trap, which makes it a special case calling for “unorthodox” policies. Paul Krugman writes:
I know that some people find this hard to understand — perhaps because they don’t want to understand — but people like me have never claimed that fiscal expansion is always and everywhere the right policy, even in response to recession…. All of the unorthodox policy recommendations and conclusions are contingent on the economy being in a liquidity trap, in which short-run nominal interest rates are up against the zero lower bound and can’t go lower.
And liquidity-trap conditions are rare; in fact, they’ve only happened twice in US history. Unfortunately, we’re living in one of those episodes right now.
Well, are we in a liquidity trap? And does the present situation require constant bursts of government spending?
Of course, Keynesians believe the answer to the first question is a resounding yes. The answer to the second logically would follow from the first: If Keynesianism really is true, only monetary policy and fiscal policy are available, and economic conditions determine their use.
The Government Alternative
Under the Keynesian paradigm, if monetary authorities cannot stimulate private spending by forcing down interest rates, then the only other avenue is for the government to borrow and create new money, and spend on its own projects. If the first option does not work, the second, by definition, must.
But in America’s Great Depression, Murray N. Rothbard said there is no liquidity trap:
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. This statement assumes that the rate of interest is determined by “liquidity preference” instead of by time preference; and it also assumes again that the link between savings and investment is very tenuous indeed, only tentatively exerting itself through the rate of interest. But, on the contrary, it is not a question of saving and investment each being acted upon by the rate of interest; in fact, saving, investment, and the rate of interest are each and all simultaneously determined by individual time preferences on the market. Liquidity preference has nothing to do with this matter.
Rothbard continued that the very things Keynesians claim will worsen an economic downturn – including falling wages and prices and liquidation of capital – actually are necessary to speed up the readjustment. The Austrian-Keynesian divide is fundamental on this point; Austrians not only reject the liquidity-trap paradigm, but also hold that the problem is boom-induced malinvested capital rather than idle capital.
Idle or Malinvested?
The distinction is important because Austrians say the economy cannot recover until the malinvested capital is transferred to other uses, liquidated, or abandoned altogether. Keynesians, on the other hand, claim that if government can spend enough money, the same capital that Austrians say is malinvested will be returned to full employment.
In other words, Keynesians hold that capital (as well as other factors of production) is homogeneous. An economy is like a cake mixture: Stir in water (money) and an economy appears. The only important ingredient is spending, and lots of it.
Austrians in contrast believe that an economy consists of heterogeneous assets that are directed by consumer choices. Thus attempts by government to drive this process only result in resources being directed to unsustainable purposes. Furthermore, Austrians hold that the current situation is not in a special case; instead, the government is justifying its actions using bad theory. Governments can neither fool Mother Nature nor violate the laws of economics.
Comment by Steve Fritzinger on 6 April 2011:
I’m struck by this part of Krugman’s argument, “And liquidity-trap conditions are rare; in fact, they’ve only happened twice in US history.”
He’s only got two data points, yet he’s absolutely certain that his policies are the right ones and demands that we spend hundreds of billions more borrowed dollars and create even more money out of thin air.
OTOH, his empirical data is twice as strong as those who point only to the Great Depression. They only have one data point.
Comment by Nick Klein on 6 April 2011:
Solid point Steve. Of course, it seems like every time Mr. Krugman writes an op-ed even, even 10 year old kids can point out the overall stupidity and logical inconsistencies in his arguments. I wish Enron was still in existence sometimes, because then he’d be advising them instead of filling NYT readers’ minds with crackpot arguments.
Comment by George Leef on 6 April 2011:
The Keynesians think of “government spending” as if it were some magical elixir that costlessly “puts unemployed resources back to work.” But in the real world, government spending devotes resources to projects and programs that politicians like, such as buying great numbers of those ridiculous airport scanners. Such political spending does nothing to create work for, say, the unemployed carpenter in Florida who had been making a nice living during the housing bubble but now is out of work. By transferring resources away from the private sector and into the hands of politicians, the Keynesian prescription inevitably means more waste and a slower adjustment for the productive sector.
Comment by American Patriot on 6 April 2011:
Krugman: “conclusions are contingent on the economy being in a liquidity trap, in which short-run nominal interest rates are up against the zero lower bound and can’t go lower.”
So, in their myopic world, Keynesians would naturally think that only if we could reduce the S/T nominal rates even further, everything would be fine. This fallacy is due to their inability to analyze situations that require multi-factorial dynamic analysis.
They would refuse to concede that anti-business, anti-wealth accumulation policies of a government have a huge role to play in economic recovery.
Comment by Fred on 6 April 2011:
Keynesian; Government spending it’s way to prosperity, and since Roosevelt 75 years ago it has been a total failure.Roosevelt kick out Adam Smith free market economy and replace Keynesian. Keynesian is like standing in a bucket and trying to lift yourself up by the handle.
Comment by Harry on 9 April 2011:
Krugman is the dweeb that we all knew in school. He found out early on that his best talent was debating an issue regardless of which side he took, he would win because he was quicker with the tongue. Soon he would defend defenseless positions and have to maintain them to keep his credibility. This is the position he finds himself in when he defends Keynesian economics. He would love to be able to renounce it but his reputation is on the line and he is stuck with making one moronic statement after another. It’s a shame he won’t renounce what he knows is bad because of the good he could do but like all liberals think, “To hell with the country, I’ll let someone else worry about it later”.
Comment by Kurt on 12 April 2011:
Given the fact that we also have most of the middle class in a debt position that is unsustainable after the market downturn – how do you guys figure that lowering nominal wages without lowering nominal debt will not further reduce productivity and employment? It really doesn’t make sense at all what you are claiming here. Furthermore, that capital wasn’t wasted. Houses were built. Developers got really rich (sure some lost their shirts as well), banks got rich, mortgage brokers got rich and so on. When the economy crashed, wages did adjust downward, substantially. It seems to me that the capital associated with the boom all ended up in the financial sector, and then the financial sector pulled credit away from good businesses, which then failed to be able to manage cashflow and pay suppliers, which caused unemployement to go up further…. And ended up with a few people who can save most of their income and move it to safe long term investments taking their capital out of the economy (which explains the trillions of American private capital that is sitting idle). So – I guess, I am not as smart as you austrians – that or I can look at the numbers and do thought experiments and you guys can’t get past your RBC dogma.