How an Economy Grows and Why It Crashes is Peter Schiff’s most recent effort in that regard. Bypassing the academic crowd and avoiding an eye-glazing academic approach, Schiff and his brother Andrew have tried to grab readers’ attention with an amalgam of allegorical storytelling and current events. They aim to promote real economic comprehension.

The book’s introduction starts with a lucid explication of the key elements of Keynesian economics—showing how John Maynard Keynes, by making “something simple seem hopelessly complex,” paved the way for acceptance of “some very stupid ideas about what makes economies grow.” In chapter 1 the authors shift into allegorical mode, weaving a tale about a Crusoe-type economy based on fishing. Here they introduce the reader to the rudiments of capital theory. The story progresses logically from there. The use of capital leads to both greater wealth and income inequality. Then comes a cogent discussion of the counterproductive effects of forced income redistribution.

Next they turn to the role of saving—how it serves as the source of credit and a cushion permitting people to get through emergencies and how, contra Keynes, it is the true key to economic growth. In addition the authors correct the common misinterpretation of deflation—not as the disaster depicted by Ben Bernanke and his ilk, but as a key channel through which prosperity spreads. They proceed to describe the benefits of free trade, dissecting the canard that it is a job-killer and pointing out that “it is not the aim of an economy to simply provide jobs, but to create jobs that maximize labor productivity.”

Notable in their discussion of government is an endorsement of restricting voting to those who pay taxes, an idea going back at least to John Stuart Mill. They argue that retreat from this stipulation accelerates a nation’s downward trajectory into an inflationary welfare state. The Schiffs elucidate the unaccounted-for implications of the many popular policies dragging economies down this path. Included among those are the replacement of a commodity standard with fiat money, subsidization of loans to politically favored sectors of the economy, and so-called “stimulus” spending—all central elements of Keynesian monetary and fiscal policy.

They finish their allegory with the inevitable upshot of those policies (given the lack of political will to incur the short-term pain that would stave it off): the decision of our international creditors to cease enabling our profligate ways by redeeming our dollars, unleashing massive price increases, and pushing our standard of living off a cliff.

It’s well argued, but I wonder if the book is written at the right level for its intended audience. It is clearly not aimed at academics, which is too bad because many of them could use it the most. Rather it is aimed at noneconomists. Yet for the totally uninitiated I fear that it may throw too much at them too fast, without sufficient explanation. One can only hope they will be interested enough to seek the requisite explanations from other sources rather than throwing up their hands in frustration.

Also, I found the pervasive fish metaphor tiresome—not to mention that fish are too perishable to ever be used as a monetary commodity. (On p. 159 the Schiff brothers do mention the advantages of precious metals as money.) While I realize this is an allegory in which some literary license is permitted, the cost of this aspect of the story in reader confusion and lack of credibility may be high.

On the other hand I do like the way each allegorical chapter is followed by a takeaway that uses the principles presented to shed light on real-world events. Knowing that the authors of this book wrote it to share the economic insights that enabled them to predict the onset of our current recession, I hope my misgivings are unfounded because the lessons are ones all of us need to master.

Austrians start by defining capital as, in Israel Kirzner’s words, “unfinished plans.”  Capital is all the elements of an entrepreneurial plan that have to be combined to produce final output, including labor (sometimes called “human capital”), machinery, raw materials, and intangibles such as particular business processes a firm uses or its connections to suppliers.

When we see capital this way, we also recognize that capital goods are heterogeneous things. Capital is not like a bucket of water from which we scoop identical cups.  Instead, capital goods, including human capital, have a limited number of specific uses to which they can be put.  As Peter Boettke puts it, capital is not like Play-Doh, which can be formed into any shape, but like Legos, the versatility of which is limited by the sizes, shapes, and interconnections of the pieces.

Austrians speak of the need for capital to be “complementary” to other capital in order for it to help create an integrated production plan.  A producer must have the “right” capital, that is, capital that “fits together.”  An important implication here is that “more” capital isn’t always better.  What firms need are pieces that fit, not just duplicates of what they already have.

Complements or Substitutes?

Consider the major sports story of the last few weeks:  LeBron James’s move to the Miami Heat of the NBA.  At first blush, this seems like a huge gain for the Heat because they now have two of the best players in the game — James and Dwyane Wade (and perhaps a third, Chris Bosh).  Economically, it might look like the Heat will be much more “productive” because they’ve added very productive human capital in the form of James.  However, from an Austrian perspective there’s a question worth asking, as Tyler Cowen has pointed out:  Are James and Wade complements or do they just substitute for one another?  If they play too much alike, will they “fit together” in the way capital goods need to?  Often the best teams in sports are ones that find good “role players” who complement one or two excellent players.

If James and Wade, for example, can’t play defense well enough or they both like to handle the ball too much, and no one else on the Heat can pick up the defensive slack or move without the ball, there will be a hole in the production plan.  Having more really productive capital isn’t useful if it is just a substitute for what you already have rather than a complement in the mixture of capital goods that are needed to produce the output.  In fact, what makes capital productive is precisely that it is complementary to other factors of production.

All these points are misunderstood by critics of the Austrian explanation of the recession.  What Austrians claim happens during the boom is that inflation drives down interest rates, creating malinvestment as entrepreneurs begin production processes with too many stages between inputs and outputs (which seems to be justified by the artificially low interest rate).  Labor gets allocated to those industries as well.

Notice that it’s not that they have over-invested in capital. Rather they have the wrong mix of capital.  If one doesn’t understand the heterogeneity of capital, that distinction is easy to overlook.

It also explains why the road to economic recovery is not a matter of just more spending and more investment in general.  Capital and labor need to restructure themselves to meet the new reality of the post-crash marketplace.  Just throwing more capital at firms won’t help; neither will trillion-dollar government spending on consumption or job training.  Only the discovery process of the market can reveal which specific capital goods and what sorts of labor are required for entrepreneurial plans to succeed in the current economy.

We don’t need “more” capital and labor. We need the “right” capital and labor. Figuring out what’s right is what markets do better than the alternatives.

Read’s pencil describes its family tree, beginning with the cedars grown in northern California and Oregon that provide the wooden slats. But he doesn’t really start with the trees. He notes that turning trees into pencils requires “saws and trucks and rope and the countless other gear used in harvesting and carting the cedar logs to the railroad siding,” and those things have to be produced before a pencil can be produced.

This is what Austrian economists call a structure of production. This structure is characterized by two closely related elements: multiple stages (distinguished by their “distance” from the consumer) and time. The pencil that eventually emerges at the end of the process must first proceed, in various states of incompleteness, through a series of stations at which components are transformed in ways consistent with making pencils. The stations themselves have to be prepared through earlier stages of production. Thus before trees can be cut down and turned into wooden slats, saws, trucks, rope, railroad cars, and other things must be produced first. Before steel can be used to make saws, trucks, and railroad cars, iron ore must be mined and processed. And so on. The same kind of description can be provided for each component of the pencil: the paint, the graphite, the compound that comprises the eraser, the brass ferrule that holds it.

Tracing the pencil’s genealogy back—to iron, zinc, copper, and graphite mines; hemp plants; rubber trees; castor beans; and much more—demonstrates the “roundaboutness” of production, the term of the early Austrian economist Eugen von Böhm-Bawerk. Much time and effort are spent not on making pencils but rather things that will—sooner or later—help to make pencils. Without central direction, entrepreneurs set up production this way because it produces more, better, and cheaper pencils more profitably than some more direct process.

Prices—particularly interest rates—coordinate all this production through time. A quantity of a resource cannot be used both at an early stage of production and a later stage simultaneously. A unit of iron could be devoted to making a ferrule machine or a machine for mining more iron—or many other things in between. Tradeoff is the rule, and consumer welfare depends on having things arranged appropriately. Time preference and the market for loanable funds—that is, interest rates—govern coordination to maximize consumer satisfaction.

Capital equipment wears out. Replacing machines, engines, vehicles, saw blades, and ropes requires money, which requires saving—that is, deferred consumption. Saving is also necessary to finance research and development so that better and cheaper machines, tools, and writing implements might be created. Remember this when Keynesian politicians and economists deride saving.

The stages of the capital structure consist in discrete, specific, scarce, and complementary things—buildings, machines, tools, materials—in particular places at particular times, all of which derive their value from the final goods they help produce. They were put in place as part of entrepreneurs’ plans, and in keeping with Austrian subjectivism, the plans give them meaning. A change in a plan might convert equipment that was once complementary to an operation into something of little or no value.

This description of the structure of production should raise no eyebrows. We see it all around. But anyone who has taken a standard economics course will know that capital is usually discussed as though it were a lump of colorless, timeless Play Doh. That conception of capital is amenable to mathematics, but that’s a case of the tail wagging the dog. Economics should be a way of thinking about the world we actually confront.

* * *

When people are nervous about the banking system, the time may not be propitious to ask if we’d be better off without government deposit insurance. But that doesn’t keep Jeffrey Miron from asking—and answering—the question. (read it now)

The current economic turmoil has thrown mainstream macroeconomics itself into turmoil. That should put the spotlight on Austrian macroeconomics. But is the mainstream capable of understanding it? Roger Garrison isn’t so sure. (read it now)

A good reason to oppose government support for scientific research is that the output will tend to be biased toward “crises” that, naturally, require government action. Global warming is a perfect example, writes Michael Heberling. (read it now)

The collapse of the housing bubble and its consequent financial disorder are signs of problems far deeper than most people think. They reveal a crisis not of the free market but of “capitalism.” Chris Sciabarra resolves the paradox. In a related article, a Freeman reprint, the late Clarence Carson also expresses doubts about “capitalism.” (read it now)

In discussions of public policy there is no shortage of things we are told we must do. Few people bother to ask whether they can be done. Steven Horwitz does. (read it now)

Our columnists have burning issues on their minds. Lawrence Reed wants to know what we owe each other. Thomas Szasz tells the tragic story of scientific genius Alan Turning. Robert Higgs discusses World War II price controls. John Stossel says protectionism made the so-called stimulus bill even worse. Charles Baird documents union abuse of workers who don’t want representation. And Chidem Kurdas, confronting those who say the Bernard Madoff Ponzi scheme justifies more government regulation, replies, “It Just Ain’t So!”

Coming under the reviewers’ microscopes are books on antiwar America, the bubble and the burst, and rating presidents.

Capital Letters features an exchange between Leland Yeager and Michael Giuliano over utilitarianism.

DeLong blithely rejects the Austrian account. In his lecture delivered January 5 in Singapore, “The Financial Crisis of 2008–2009: Understanding the Causes, Consequences—and Possible Cures,” he fabricates a “Marx-Hoover-Hayek axis” (complete with adjoined photos of this unlikely trio) and then offers a brief and ill-informed critique under the heading “The ‘Austrian’ Story in a Nutshell.”

A true-to-Hayek nutshell version of the Austrian theory is not difficult to produce. The central bank is central to our understanding of the current crisis. The Federal Reserve under the leadership of Alan Greenspan kept interest rates too low during 2003 and 2004 and then ratcheted the rates steeply upward. Time-consuming investments that were initiated while cheap credit made them artificially attractive were then made prohibitively costly to carry through. Macroeconomically, that sequence translates into an Austrian-style boom and bust. The background against which the story unfolded was a long-running, politically motivated sequence of housing policies whose dubious goal was to increase home ownership beyond what mortgage markets themselves would allow. The actual effect of the various policies was to desensitize both lenders and borrowers to the risk of default, causing mortgage markets and hence housing markets to play leading roles in this particular boom-bust episode.

The Austrian theory couldn’t be more tailor-made for understanding our current situation. Dealing with the unfortunate consequences of artificially cheap credit, a memorable passage in Mises’s Human Action (3rd ed., 1966, p. 560) alludes to an overbuilt housing market:

The whole entrepreneurial class is, as it were, in the position of a master builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan . . . [that cannot be fully executed because] the means at his disposal are not sufficient. He oversizes the groundwork and the foundation and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure.

The foiled plans in Mises’s parable represent the upper turning point of the business cycle. The subsequent compounding of the downturn in the form of a downward spiral into deep recession should not distract attention from the underlying problem of the credit-induced misallocation of resources. The solution must entail, in the first instance, a reallocation of those misallocated resources.

If credit creation by the central bank was the cause of the problem, it is doubtful that still more credit creation is the solution. Similarly, if investment activity was overstimulated by cheap credit, it is doubtful that a stimulus package will hasten recovery. Why, then, isn’t there a general recognition of the implausibility of these textbook solutions? And why don’t mainstream macroeconomists see the direct applicability of the Austrian theory and the appropriateness of a market solution to the crisis?

Votes Now, Bust Later

For the economist-turned-policymaker, the answer is simple. Policies based on mainstream thinking—cheap credit and stimulus packages—are politically attractive, a circumstance that makes any other theory, particularly as it might apply to the long run, wholly irrelevant. Attempts to rekindle the boom also satisfy the “don’t-just-stand-there” criteria for political viability. In the long run a boom will get you a bust; but in the short run, a boom will get you votes. No doubt, many elected officials are oblivious to the first part of this long-run/short-run distinction. And virtually all those not so oblivious see the second part as trumps.

For academic macroeconomists, especially for those trained and employed by top-tier universities, we need a two-part answer to our question. For Part I we must recognize that economists who were trained at Harvard or MIT and hold a faculty position at Berkeley or Princeton have trouble grasping the Austrian theory. They learned their (short-run) macroeconomics and their (long-run) growth theory in two different sets of courses. The capital theory that unites these two subject areas in the Austrian literature was effectively out of play in both sets. In mainstream macro, where business cycles were discussed, capital is assumed to be fixed. In mainstream growth theory, where cyclical movements are assumed away, capital is allowed to grow or to shrink, but it enters the theory as a holistically conceived capital stock.

By contrast, the inherent time dimension in the economy’s capital structure makes capital theory a natural common denominator for Austrian macro-economics and Austrian growth theory. Capital is a sequence of stages of production; its temporal structure is a key macroeconomic variable. Interest rates that reflect people’s preferred tradeoff between consuming now and consuming later guide capital creation and allow for sustainable growth. Almost as a corollary, interest rates that are distorted by central-bank policy misguide capital creation and give rise to unsustainable growth. The inevitable bust (in the recent and earlier episodes) is a dramatic manifestation of the growth rate’s unsustainability.

To mainstream macroeconomists, the mix of cycles, growth, and the temporal allocation of resources makes Austrian theory appear as a disorienting mishmash. The mainstreamers are not won over; they are simply flummoxed. At best, they will try to fit piecemeal the various propositions put forth by the Austrians into an otherwise mainstream theoretical framework. Distortions of the capital structure get translated into unwarranted changes in the size of the capital stock; the plausibility of entrepreneurs being misled by cheap credit gets judged in the light of presumed “rational expectations.” The unemployment of labor during the period of capital restructuring gets questioned on the basis of the efficient-market hypothesis. Individually, the pieces don’t fit, and so collectively the Austrian propositions are rejected wholesale. (Notice that the Austrian theory is better received by Wall Street analysts trained in finance and attuned to the real economy than by academic macroeconomists.)

Part II of the answer to “Why don’t the mainstreamers see the Austrian theory’s relevance?” actually deals with a follow-on question. “Why don’t they at least make the effort to learn what the Austrian theory is?” After all, economists who study and teach at top-tier universities are intelligent people who could learn the Austrian theory. A little reflection suggests that while they surely have the ability, they lack the motivation. For a seasoned member (or even an upstart member) of the Berkeley or Princeton faculty, studying Austrian economics is just not a career-enhancing activity.

Theories that they do know, which include New Keynesian, New Classical, and Real Business Cycle Theory, fail to incorporate capital theory in any meaningful way. And although advertised as “new” and “real,” none of these theories have more than a tenuous link to current economic reality. Further, these mainstream theories have now begun to merge together into technically demanding and other-worldly constructions called Dynamic Stochastic General Equilibrium (DSGE) models. For mainstream macroeconomists, the DSGE models are the wave of the future. They are the vehicles for publications and professional advancement. (Googling “Dynamic Stochastic General Equilibrium” yields more than 80,000 results.) Any attention to the Old Austrian theory, then, can only divert their careers in an unrewarding direction.

When the mainstreamers are called on to make a public statement about the current economy or to make a policy recommendation, they find their DSGE models wholly unserviceable. And so they simply fall back on the simplest, principles-level version of these complex formal models—which, not surprisingly, is the Old Keynesian theory. Their policy positions are based on the decades-old textbook construction in which earning and spending are locked into a spiral-prone circular flow—and in which countering a downward spiral requires a deficit-financed stimulus package.

Austrian Theory in a Mainstream Straitjacket

The short final section of DeLong’s Singapore lecture, his nutshell rendition of the “Austrian Story,” presents us with a particularly significant case study of the mainstream perspective on Austrian theory. During the several months before his January lecture, DeLong had multiple encounters with the Austrian theory as applied to our current financial crises. The Cato Institute’s 26th Annual Monetary Conference (held in November 2008) was titled “Lessons from the Subprime Crisis.” Among the dozen or so papers presented at that conference, the Austrian school was well represented. Although DeLong was not a conference participant, he reacted on December 8 to an online version of Lawrence H. White’s conference paper, “What Really Happened,” with a critique titled, “Liquidity, Default, Risk.” White responded on December 10 with an insightful defense of the Austrian theory. This exchange of ideas was then followed by still more contributions to “The Conversation” stemming from the White paper and including four additional comments by White. (The DeLong-White exchange is accessible through www.catounbound.org, and all the conference papers appear in the winter issue of the Cato Journal.)

So what effect did this virtual immersion in Austrian theory have on DeLong’s understanding? The answer: little or none. Although his January “nutshell” is just too small to contain much understanding at all, it does contain evidence of the continuing fundamental misunderstandings typical of mainstream critiques.

DeLong’s explanation of the Austrian view makes reference only to “the economy’s capital stock”—that phrase from mainstream macroeconomics that treats capital holistically. Willful or not, DeLong has distorted the Austrian theory by force-fitting it into his mainstream macroeconomic framework. And in DeLong’s rendition of the Austrian view, we see that the “overinvestment” that characterized the boom implies that “the economy’s capital stock needed to shrink.” A two-panel diagram showing “boom” and “crash” is used to depict the sequence of overinvestment and shrinkage. The demand for risky assets first rotates up producing the boom and then rotates back down precipitating the crash. The Austrians themselves would claim, instead, that the malinvestment (Mises’s term) that characterizes the boom implies the need for a capital restructuring. In other words, the allocation of resources within the capital structure has to be brought in line with post-boom market rates of interest. This restructuring takes some time and is best achieved, in the Austrians’ view, by the market itself.

From the Time Dimension to the Moral Dimension

Turning a blind eye to the notions of malinvestment and capital restructuring, DeLong quickly shifts ground from economics to ideology and from F. A. Hayek to Herbert Hoover. (We will take DeLong’s inclusion of Marx in his discussion as pure hyperbole.) DeLong takes the Austrians’ call for a market solution (capital restructuring) rather than a government solution (rekindling the boom) as justification for denigrating the Austrians as “liquidationists,” a label popularized by DeLong himself in earlier articles and associated in his own thinking with Hayek, Hoover, and Hoover’s treasury secretary, Andrew Mellon. The specific recommendations that Mellon supposedly offered for dealing with the 1929 crash and its aftermath are, by themselves, almost enough to call this association into question:

Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.

Significantly, DeLong’s broad-brush use of the term “liquidationism” was criticized by White in a 2008 paper titled, “Did Hayek and Robbins Deepen the Great Depression?” (Journal of Money Credit and Banking, June issue). In arguing the absence of a Hayek-Hoover connection, White is convincing on two key points. First, sheer chronology precludes the possibility of Hayek having a timely influence on Mellon and/or Hoover. Hayek’s first English-language statement of the Austrian theory was not published until 1931. Besides, a much more obvious basis for Mellon’s thinking was the fallacious Real Bills Doctrine, which was written into the legislation that created the Federal Reserve System. Second, there is no evidence that the above quoted passage can actually be attributed to Mellon. It comes from Hoover’s Memoirs (1952) and reads like a caricatured rendition of Mellon’s views—a rendition that sets the stage for Hoover’s rejection of those views.

For the Austrians the liquidation of malinvestments is essential to the economy’s recovery. Resources need to be reallocated. Hence, any government spending program that serves to rekindle the housing boom or even to keep resources from leaving the housing industry is counterproductive. It locks in the misallocated resources. Similarly, restoring macroeconomic health requires the liquidation of many other long-term or early-stage investments whose expected profitability depended on artificially low borrowing costs.

This needed liquidation does not imply that “a panic would be not altogether a bad thing,” a judgment that DeLong also attributes—via Hoover—to Mellon. What Mellon (or Hoover) called a panic, Hayek called a “secondary contraction,” meaning a self-reinforcing spiraling downward of economic activity that causes the recession to be deeper and/or longer-lasting than is implied by the needed liquidation of the malinvestment. Hayek argued, in effect, that the “ideal” policy would be one that allows the needed liquidation to proceed at market speed while the monetary authority curbs the secondary contraction (the panic) by maintaining a constant flow of spending. In terms of the equation of exchange (MV=PQ), Hayek argued that the ideal policy was to keep MV—and hence PQ—constant by increasing the money supply (M) just enough to offset declines in money’s velocity of circulation (V). Hayek used the word “ideal” in recognition that the monetary authority may lack both the technical ability and the political will actually to implement that policy. (It would lack the technical ability because it would have no way of getting timely information on the changes in money’s circulation velocity; it would lack the political will because pulling money out of the economy when eventually the velocity begins to rise is a politically unpopular thing to do.) But in any case, Hayek and the Austrians generally regarded the secondary deflation as “altogether a bad thing.” (In Hayek’s later writings, he favored a decentralized monetary system—in which market forces, rather than an ideally managed central bank, would govern changes in the money supply.)

Mellon is charged (by DeLong and many others) with having a “moral objection” to curbing even the secondary contraction. This moral dimension to Mellon’s supposed liquidationism tends to get imputed to the Austrian view as well. DeLong quotes Martin Wolf (Financial Times, Dec. 23, 2008) at some length on this point. Wolf insisted (with a bow to Keynes) that “we should approach an economic system not as a morality play but as a technical challenge.”

It is worth noting here that characterizing the Austrian Story as a morality play is not original with Wolf—and certainly not with DeLong. Most likely, this particular putdown comes from Paul Krugman, whose understanding of Austrian theory rivals DeLong’s. Krugman’s introduction to the 2006 printing of John Maynard Keynes’s General Theory of Employment, Interest, and Money contains the following passage:

Keynes’s limitation of the question [about a depressed economy] was powerfully liberating. Rather than getting bogged down in an attempt to explain the dynamics of the business cycle—a subject that remains contentious to this day—Keynes focused on a question that could be answered. And that was also the question that most needed an answer: Given that overall demand is depressed (never mind why), how can we create more employment? A side benefit of this simplification was that it freed Keynes and the rest of us from the seductive but surely false notion of the business cycle as morality play, of an economic slump as a necessary purgative after the excesses of a boom. By analyzing how the economy stays depressed, rather than trying to explain how it became depressed in the first place, Keynes helped bury the notion that there’s something redemptive about economic suffering.

The Austrian Story is not a morality play. It is a piece of economic analysis. Nor is it just some variation on a theme that can be understood in terms of the analytical framework of mainstream macroeconomics. Rather, Mises and Hayek offered a more encompassing macroeconomic framework, one that illuminates the market mechanisms that allocate resources among the temporally defined stages of production and traces the intertemporal misallocation of those resources to misguided or politically motivated policies of the central bank.

It is important to see that the whole focus of mainstream macroeconomics, and certainly DeLong’s focus, is fundamentally different from the focus of the Austrian economists. The difference, fully recognized by White in his response to DeLong, is captured in Krugman’s introduction to Keynes’s General Theory. Keynes suggested remedies for the ongoing depression without bothering himself about just how the economy came to be depressed in the first place. Throughout the Singapore lecture, DeLong, following Keynes, argues as if it is simply in the nature of capitalism that there are waves of speculation followed by a collective quest for liquidity—for more liquidity than can be readily accommodated in a modern capital-intensive economy. The central bank comes into play only to counter the economy’s wealth-destroying gyrations.

Hayek focused on the dynamics of the preceding boom, thinking that the question of how the economy came to be depressed was the most interesting and challenging question, and believing that a satisfactory answer to that question was a strict prerequisite to figuring out how (and how not) to deal with the depressed economy.

An Austrian Perspective on Suffering

There is nothing “redemptive about economic suffering.” Krugman, Wolfe, and DeLong are right about that. There is also nothing redemptive about the suffering of the Austrian school in the wake of ill-informed criticism. But the Austrian ideas will continue to suffer as long as mainstream macro continues to develop along its current path. And the suffering of the economy will continue—and intensify—as long as policymakers, following their political instincts and enjoying the support of mainstream economists, opt for ever-bigger stimulus packages to be financed by mushrooming debt.

Here’s what actually happened. During the roundtable segment of the show, Will said, “[O]ne of the ways we turned a depression into the Great Depression . . .
was that there were no rules and investors went on strike because the government was completely improvising. Net investment was negative through almost all of the ’30s because, again, people did not know the environment in which they were operating because the government had the fidgets and would not let rules and markets work.”

Krugman responded, “Well, it’s not the way I read the history. . . . No, the negative net investment was because, you know, when you have 20 percent unemployment and all the factories are standing idle, who wants to build a new one? You don’t need to invoke the government to explain that.”

Point Krugman? Wrong.

If Krugman took the Mises-Hayek capital and trade-cycle theory seriously he’d realize that the idle factories in the 1930s represented malinvestment induced by Federal Reserve credit expansion in the 1920s. By lowering the interest rate and falsely signaling an increase in saving (that is, a preference for future over present goods), this policy shifted resources from later stages of production (closer to the consumer) to earlier stages of production. Unfortunately, those who think of capital as a heap of uniform, monochrome Play-Doh aren’t sensitive to this point. Capital is capital is capital. That’s why Krugman can’t understand why someone would want to invest in new facilities when others stand idle.

When the 1920s inflationary boom ended, as it had to because it was artificially induced and there weren’t enough resources for both the early stages and the later stages (where consumers wanted them), the malinvestments had to be liquidated and scarce resources had to be redeployed. But since capital consists not of malleable Play-Doh but rather of discrete things—buildings, machines, tools, materials—with particular characteristics, many of these products of malinvestment were unsuitable for other purposes. They couldn’t simply, costlessly, and instantly be moved and employed in later stages of production. Hence the idle factories. This was wasted capital brought about by the credit expansion. This was the Depression.

If the economy was to recover, new investment consistent with consumers’ actual preferences had to be undertaken. But that required time and saving—that is, deferred consumption, not the pumped-up consumer spending Krugman favors. It also required a stable political environment in which investors could be confident their property was safe from government predation. Unfortunately, thanks to tax increases, an unending stream of interventionist programs, and threatening antibusiness rhetoric, FDR’s government failed to provide that environment.

Krugman’s flip remark to Will is thus a perfect illustration of what is wrong with Keynesian economics. P.S. Will and Krugman believe it took World War II—“an enormous public works program,” in Krugman’s words—to end the depression. Both are wrong about that, as Robert Higgs documents in Depression, War, and Cold War. Ending unemployment with a military draft and boosting GNP through military contracts do not a recovery make. Living standards could hardly rise amid ration books, consumer-goods shortages, and war production.

This assessment was offered up late last year in the online magazine Slate by Paul Krugman, 1991 winner of the prestigious John Bates Clark Award.

A few weeks before Krugman wrote that, Gene Epstein, economics editor of Barron’s, profiled this Yale-bred, MIT-based economic theorist. Epstein’s article was largely positive and wholly respectful. But in a mildly critical tone, Epstein wondered if Krugman hadn’t committed an error of omission. His writings on recessions seemed to suggest that he knew little or nothing about Hayek’s theory of the business cycle, a theory built on the cumulative efforts of Carl Menger, Eugen von Böhm-Bawerk, and Ludwig von Mises. Krugman conceded that he wasn’t familiar with the Austrian theory.

One is reminded of the notorious episode in which John Maynard Keynes reviewed Mises’s Theory of Money and Credit, which was published in German. He faulted Mises for failing to offer anything original and then later remarked that when he read German, he understood only what he already knew. If we get our appreciation of Hayek through Krugman, we can credit Hayek for very little. Unlike Keynes, though, Krugman cannot invoke language as an excuse. Hayek did not get the Nobel Prize for his political views; he got it for his work on business-cycle theory. Why would Krugman not be completely familiar with Hayek’s contributions? Stay tuned.

Clearly not a follower of Austrian theorizing, Krugman is, if anything, a quick study. On the same occasion in which he denied Hayek any standing as an economic theorist, he launched a vitriolic attack on the Austrians and their “hangover theory” of recessions. “I regard [their theory] as being about as worthy of serious study as the phlogiston theory of fire.” Though he failed to identify the Barron’s article or its author as the spark that set off this firestorm, he was clearly reacting to Epstein.

“Hangover theory” is a term obviously intended to denigrate the Austrian account of the unsustainable boom. Yet it is descriptive of many—if not most—modern business-cycle theories. The idea that booms lead to busts as drinking binges lead to hangovers is at home in both Monetarism and New Classicism. Even our sophomore-level college textbooks feature a stilted version of the hangover theory. In the late 1970s, the analogy between the abuse of monetary tools and the abuse of illegal substances became so well understood in the financial world that the argument by analogy was nearly reversed. A memorable cartoon of the period showed a balding Wall Street banker having a heart-to-heart with his errant teenage son: “Think of it this way, Timmy: Taking drugs is kinda like increasing the money supply. . . .”

The Austrian hangover is unique. The misallocation of resources during the period of artificially cheap credit has the feel of genuine growth, but these good feelings are followed by bad ones. The commitment of too many resources to projects that will yield output only in the remote future has as its counterpart an undue scarcity of resources for producing output in the near and intermediate future. In time the misallocation becomes apparent, after which follows a period of liquidation and reallocation—in a word: a recession.

None of this is to deny that a sharp increase in money demand (or a collapse in the money supply) can seriously retard recovery—as certainly happened in the 1930s. But Krugman would have us believe that monetary disequilibrium is the whole story: People, for some reason, want to hold more money than currently exists. Accordingly, his solution is simply to print the money up and let them hold it.

Krugman’s view of recessions is best put in perspective by comparing it with the contrasting views of Keynes and Hayek. These arch-rivals of the 1930s were in agreement that the increase in money demand, the “scramble for liquidity,” was a secondary aspect of the downturn but in disagreement about what the primary problem was. Keynes thought it was investment demand, which in a decentralized economy is prone to collapse. Hayek thought it was malinvestment induced by shortsighted or politically motivated actions of the central bank. [Editor's note: See Richard Ebeling's article, p. 28.] Krugman elevates what both Keynes and Hayek saw as a secondary aspect to the status of the primary problem. And then, creating difficulties for the historian of thought, he attributes the high-money-demand theory of recessions to Keynes himself.

Presumably rejecting all hangover theories, Krugman pronounces the Austrian variety “intellectually incoherent”—largely on the basis of a telling question: “[How can] bad investments in the past require the unemployment of good workers in the present?” Krugman’s implicit answer: They can’t—and therefore we needn’t pay any attention to Hayek. (The question itself is a good one and is likely to find its way onto macro exams at Auburn University.)

Emphasizing the time element in the economy’s capital structure, a Hayekian would argue that investment involves the employment of resources in a particular sequential pattern. During the downturn, good workers are out of work because the capital they need to work with is in short supply, having been committed to long-term projects now in need of liquidation. Krugman’s response (“Well, fine. Junk the bad investments and write off the bad loans.”) is all too facile. His advice is well taken, but the market process that implements it is time-consuming. During the junking and capital restructuring the demand for much of the labor force (labor whose capital complement has not yet been recreated) is low. And low demand translates into unemployment—except under the decidedly un-Austrian assumptions of instantaneous wage-rate adjustment and near-infinite labor mobility.

Recognizing that in Austrian theory the unemployment is somehow related to capital restructuring, Krugman poses another question: “Why doesn’t the investment boom—which presumably requires a transfer of workers in the opposite direction [from short-term projects to long-term projects]—also generate mass unemployment?” Gottfried Haberler asked the same question in his 1937 book, Prosperity and Depression. The answer is that during the cheap-credit boom, there is a net increase in labor demand. And because of the low interest rate, many workers are bid away from jobs in the late stages of production and into jobs in the early stages. During the downturn, however, there is a net reduction in labor demand. As liquidation gets underway, workers are released from the higher stages and (eventually) reabsorbed elsewhere in the economy.

Both of these future exam questions have been answered by drawing on Hayek’s contributions. Significantly, both answers involve heavy doses of capital theory, which serves as the underpinning of the Austrian theory of the business cycle. One seemingly permanent effect of the Keynesian Revolution was to tear macroeconomics loose from these underpinnings. Today, capital theory simply has no standing in mainstream macroeconomics. Accordingly, Hayek has no standing in the eyes of Krugman and other modern mainstream macroeconomists. It is a pity.

—Roger W. Garrison
Department of Economics
Auburn University