---------- Forwarded message ----------
Date: Fri, 4 Dec 1998 15:18:24 -0800
From: John Gelles <[EMAIL PROTECTED]>
Reply-To: THE CYBERSPACE SOCIETY LIST <[EMAIL PROTECTED]>
To: Multiple recipients of list CYBER-SOC <[EMAIL PROTECTED]>
Subject: Debt and Depression versus Keynes and Krugman
As an antidote to worries over debt and
coming depressions, here are my thoughts done
by a better scholar. -- John Gelles
The following is a from Slate Magazine at
http://www.slate.com and is copyrighted
material owned by Slate and the author
---------- begin Slate's Krugman ----------
The Dismal Science
The Hangover Theory
Are recessions the inevitable payback for good times?
By Paul Krugman
(posted Thursday, Dec. 3, 1998)
A few weeks ago, a journalist devoted a substantial part of a
profile of yours truly to my failure to pay due attention to the
"Austrian theory" of the business cycle--a theory that I regard as
being about as worthy of serious study as the phlogiston theory of
fire. Oh well. But the incident set me thinking--not so much about
that particular theory as about the general worldview behind it. Call
it the overinvestment theory of recessions, or "liquidationism," or
just call it the "hangover theory."
It is the idea that slumps are the price we pay for booms,
that the suffering the economy experiences during a recession
is a necessary punishment for the excesses of the previous
expansion.
The hangover theory is perversely seductive--not because it
offers an easy way out, but because it doesn't. It turns the wiggles
on our charts into a morality play, a tale of hubris and downfall. And
it offers adherents the special pleasure of dispensing painful advice
with a clear conscience, secure in the belief that they are not
heartless but merely practicing tough love.
Powerful as these seductions may be, they must be resisted--for the
hangover theory is disastrously wrongheaded. Recessions are not
necessary consequences of booms. They can and should be fought, not
with austerity but with liberality--with policies that encourage
people to spend more, not less. Nor is this merely an academic
argument: The hangover theory can do real harm. Liquidationist views
played an important role in the spread of the Great Depression--with
Austrian theorists such as Friedrich von Hayek and Joseph Schumpeter
strenuously arguing, in the very depths of that depression, against
any attempt to restore "sham" prosperity by expanding credit and the
money supply. And these same views are doing their bit to inhibit
recovery in the world's depressed economies at this very moment.
The many variants of the hangover theory all go something like
this: In the beginning, an investment boom gets out of hand. Maybe
excessive money creation or reckless bank lending drives it, maybe it
is simply a matter of irrational exuberance on the part of
entrepreneurs. Whatever the reason, all that investment leads to the
creation of too much capacity--of factories that cannot find markets,
of office buildings that cannot find tenants. Since construction
projects take time to complete, however, the boom can proceed for a
while before its unsoundness becomes apparent. Eventually, however,
reality strikes--investors go bust and investment spending collapses.
The result is a slump whose depth is in proportion to the previous
excesses. Moreover, that slump is part of the necessary healing
process: The excess capacity gets worked off, prices and wages fall
from their excessive boom levels, and only then is the economy ready
to recover.
Except for that last bit about the
virtues of recessions, this is not a bad story about investment
cycles. Anyone who has watched the ups and downs of, say, Boston's
real estate market over the past 20 years can tell you that episodes
in which overoptimism and overbuilding are followed by a bleary-eyed
morning after are very much a part of real life.
But let's ask a seemingly silly question:
Why should the ups and downs of investment
demand lead to ups and downs in the economy as a whole?
Don't say that it's obvious--
although investment cycles clearly are associated with
economywide recessions and recoveries in practice, a theory is
supposed to explain observed correlations, not just assume them. And
in fact the key to the Keynesian revolution in economic thought--a
revolution that made hangover theory in general and Austrian theory in
particular as obsolete as epicycles--was John Maynard Keynes'
realization that the crucial question was not why investment demand
sometimes declines, but why such declines cause the whole economy to
slump.
Here's the problem: As a matter of simple arithmetic, total
spending in the economy is necessarily equal to total income (every
sale is also a purchase, and vice versa). So if people decide to spend
less on investment goods, doesn't that mean that they must be deciding
to spend more on consumption goods--implying that an investment slump
should always be accompanied by a corresponding consumption boom?
And if so why should there be a rise in unemployment?
M ost modern hangover theorists probably don't even realize this is a
problem for their story. Nor did those supposedly deep Austrian
theorists answer the riddle. The best that von Hayek or Schumpeter
could come up with was the vague suggestion that unemployment was a
frictional problem created as the economy transferred workers from a
bloated investment goods sector back to the production of consumer
goods. (Hence their opposition to any attempt to increase demand: This
would leave "part of the work of depression undone," since mass
unemployment was part of the process of "adapting the structure of
production.")
But in that case, why doesn't the investment boom--which
presumably requires a transfer of workers in the opposite
direction--also generate mass unemployment? And anyway, this story
bears little resemblance to what actually happens in a recession, when
every industry--not just the investment sector--normally contracts.
As is so often the case in economics (or for that matter in any
intellectual endeavor), the explanation of how recessions can happen,
though arrived at only after an epic intellectual journey, turns out
to be extremely simple.
A recession happens when, for whatever reason,
a large part of the private sector tries to increase its cash reserves
at the same time.
Yet, for all its simplicity, the insight that a slump
is about an excess demand for money makes nonsense of the whole
hangover theory. For if the problem is that collectively people want
to hold more money than there is in circulation, why not simply
increase the supply of money?
You may tell me that it's not that simple,
that during the previous boom businessmen made bad investments
and banks made bad loans. Well, fine. Junk the bad investments and
write off the bad loans. Why should this require that perfectly good
productive capacity be left idle?
T he hangover theory, then, turns out to be intellectually incoherent;
nobody has managed to explain why bad investments in the past require
the unemployment of good workers in the present.
Yet the theory has
powerful emotional appeal. Usually that appeal is strongest for
conservatives, who can't stand the thought that positive action by
governments (let alone--horrors!--printing money) can ever be a good
idea. Some libertarians extol the Austrian theory, not because they
have really thought that theory through, but because they feel the
need for some prestigious alternative to the perceived statist
implications of Keynesianism.
And some people probably are attracted
to Austrianism because they imagine that it devalues the intellectual
pretensions of economics professors. But moderates and liberals are
not immune to the theory's seductive charms--especially when it gives
them a chance to lecture others on their failings.
Few Western commentators have resisted the temptation to turn
Asia's economic woes into an occasion for moralizing on the region's
past sins. How many articles have you read blaming Japan's current
malaise on the excesses of the "bubble economy" of the 1980s--even
though that bubble burst almost a decade ago? How many editorials have
you seen warning that credit expansion in Korea or Malaysia is a
terrible idea, because after all it was excessive credit expansion
that created the problem in the first place?
And the Asians--the Japanese in particular--take such
strictures seriously. One often hears that Japan is adrift because its
politicians refuse to make hard choices, to take on vested interests.
The truth is that the Japanese have been remarkably willing to make
hard choices, such as raising taxes sharply in 1997. Indeed, they are
in trouble partly because they insist on making hard choices, when
what the economy really needs is to take the easy way out.
The Great Depression happened largely
because policy-makers imagined that
austerity was the way to fight a recession; the not-so-great
depression that has enveloped much of Asia has been worsened by
thesame instinct.
Keynes had it right: Often, if not always, "it is ideas,
not vested interests, that are dangerous for good or evil."
If you didn't click the link in the article, here's a quick review of
the (misguided) thoughts of von Hayek and Schumpeter. [CLICK]
A libertarian publication called the New Australian offers a vehement
assertion of the superiority of Austrian business cycle theory over
Keynesianism. If you figure out what the author is saying, let me
know. My earlier Slate piece "Baby-Sitting the Economy" offered a
hangover-free parable that explains how recessions happen and how they
can be cured. An essay by Bradford De Long about the Great Depression
contains some eye-opening quotes from von Hayek and Schumpeter. As
their contemporary Ralph Hawtrey put it, they were "[c]rying, 'Fire!
Fire!' in Noah's flood."
Paul Krugman is a professor of economics at MIT and the author, most
recently, of The Accidental Theorist and Other Dispatches From the
Dismal Science. His home page contains links to many of his other
articles and essays.
---------- end copyrighted material: Slate's Krugman ----------
