38 Responses to “Krugman’s “hangover theory”, revisited.”

1. franko writes:

   i think the reason busts go down precipitously is the duration difference between booms and busts – booms typically occur over long periods, and the later boomish phase is built on years of monotone (or relative to the bust, monotone) steadiness – the bust unwinds the N years of boom in M years, M

   December 27th, 2008 at 3:59 pm PST

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2. groucho writes:

   From Galbraith….the bezzle

   “To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years elapse between the commission of the crime and its discovery. (This is the period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s businesses and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle.

   “In good times people are relaxed, trusting, and money is plentiful, But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.
   
   One of the uses of depression is the exposure of what auditors fail to find. Bagehot once observed: “Every great crisis reveals the excessive speculations of many houses which no one before suspected.”

   December 27th, 2008 at 4:20 pm PST

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3. BSG writes:

   Steve – I think there is something you may be missing in contemplating what kind of boom leads to a widespread bust: the role of money/credit created out of thin air (unbacked by production, defined broadly) either through loosened standards of fractional reserve lending or directly by a central bank.

   Indeed, without that easy money-from-nothing, while poor investments requiring an adjustment are quite possible, probably even likely, in an economy of even moderate complexity they will rarely be large enough and widespread enough simultaneously to cause a large overall bust. With large amounts of newly created fiat money, the opposite is true.

   You’re one of the few voices that properly expressed the apparent _inevitability_ of some recessions, in contrast with the straw-man _desirability_ of recession. I think an analysis of the pernicious effect of newly created easy money/credit and the distortion it causes can illustrate why some busts are indeed inevitable.

   Re. Krugman’s comment on voluntary unemployment, I wonder if there as well he is setting up a straw man. By official definition as used in BLS reports, as I understand it, an unemployed person is someone who would rather be employed but isn’t. I haven’t heard of anyone arguing that someone chooses to be involuntarily unemployed. Similarly, I haven’t heard anyone disputing the notion that there are people that choose to not be empoyed (e.g. retired.) I’m probably missing something.

   I also noted in Krugman and DeLong the mocking tone, which is a common response of the orthodox when challenged (it used to be worse, see Galileo Galilei, but I digress.)

   December 27th, 2008 at 4:43 pm PST

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4. groucho writes:

   “Krugman is absolutely correct to inveigh against the “morality play” that sometimes seeps into the Austrian rhetoric surrounding recessions. Personally, I think morality play deserves a much larger place in economics than it currently has, but a fable in which masses of innocents suffer to absolve the sins of the reckless wealthy is hardly moral.”

   Steve, Krugman(and most Keynesians) are wrong. Economics is at its very heart a morality play. Dropping “political” from political economy was a huge mistake.

   Human nature and its “social stratification” conflict is the core driver throughout history in all but a few societies &economic systems.

   At the core is the “Matthew Effect”.

   “For unto everyone that hath shall be given, and he shall have abundance. But from him that hath not shall be taken away even that which he hath”

   The “innocents” are exploited every hour, every day and every year. The BOOM accelerates the “bezzle” and increases the social stratification process. The BUST exposes the fraudulent schemes and allows for some social healing between the classes.

   If Obama wishes to shrink the inequality in any meaningful way he will have to let the bust run its course and expose as much of the fraud as possible.

   Only then, should energy be expended on US economic expansion.

   December 27th, 2008 at 5:15 pm PST

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5. Thomas Barker writes:

   I don’t think Krugman has been to Canary Wharf. When I was down there for lunch last week, a friend excused himself for 5 minutes to pick up his Citi redundancy package, mused about how he’d really just been overpaid to build simple data entry apps over&over again, then talked about getting back to scientific computing and data analysis.

   Another friend of mine moved from modelling brain functions to modelling with profits insurance bond portfolios. Not sure if he’s moved back again yet :-)

   December 27th, 2008 at 5:25 pm PST

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6. JKH writes:

   Economic booms are about momentum investing in real assets.

   Stock market booms are about momentum investing in financial assets.

   Momentum is subject to Stein’s law – “If something cannot go on forever, it will stop,”

   I don’t normally engage in Greenspan bashing, but what was weird about him is that he was a momentum cheerleader who apparently didn’t know about Stein’s Law – with respective to any of technology or housing or productivity or even the current account deficit. His intellectual prowess was impressive but slightly out of control with respect to the constraint of finiteness. Not good for a central banker.

   Slowing down momentum investing may help “rebalance” the macro portfolio as we go along and help with real investment diversification in the long run.

   The global population of financial investors is disproportionately weighted toward those who are basically ignorant about real economic investing. There’s good reason for this.

   The flow of financial investing is driven by the turnover of outstanding financial stock – $ 500 trillion or whatever that big number is that represents the supply of global investments in stocks, bonds, and other financial things.

   The flow of real investing as a dynamic decision process is tiny by comparison. It’s not a turnover of outstanding stock at all. It’s a percentage of GDP as we go along.

   There’s no way that the information sets between these two different planes of investing can ever be fully integrated – any more than the Atlantic Ocean can be with Niagara Falls.

   Finally, look at a history of interest rates over the past 80 years – and then tell me that you can ever formulate a theory of boom and bust that fits consistently within that mountainous and formidable symmetry.

   (Didn’t Kondratiev have something to say about this sort of thing?)

   December 27th, 2008 at 8:00 pm PST

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7. Devin Finbarr writes:

   <i>doesn’t explain why there isn’t mass unemployment when bubbles are growing as well as shrinking </i>

   The two reasons seem to be:
   
   1) monetary dilution ( the bubble growing) happens gradually. Contractions happen suddenly.
   
   2) During a dilution, businesses can pass increased input prices onto the consumer. During a contraction, businesses cannot pass lower prices back onto creditors. Thus, businesses (and consumers) go bankrupt and unemployment results.

   <i>doesn’t explain why recessions reduce unemployment across the board, not just in industries that were bloated by a bubble.</i>

   The bubbles causing the business cycle are always credit bubbles. Credit is so widespread a credit contraction affects most industries.

   Steve-

   The basic problem with both bonds and stocks is that people have been buying them as collectibles, not as cash flows. IE – people buy a stock with the intention of selling it to someone else, not with the idea of making money off of dividends. Or people buy a share in a money market fund that holds long term bonds with the intention of selling the shares to someone else, not the intention of holding the bond to maturity.

   A collectible is valuable precisely because everyone else also believes it is valuable. Thus the retail investor is being smart and rational.

   The problem is that bonds and stocks should not be trading as collectibles. People should only invest based on expected cash flow. But from 2000-2007, the combination of rapid monetary dilution, artificially low interest rates, and a flat yield curve thanks to maturity transformation, resulted in CD’s being a terrible investment. Any item with a fixed supply – stocks, gold, and some real estate – was a much better investment. Of course, when the dilution turned off, stocks became a terrible investment, and CD’s became a good investment.

   The real solution is that the government needs to stop diluting the money supply.

   December 27th, 2008 at 8:48 pm PST

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8. Vijay writes:

   I remember Tyler Cowen http://www.marginalrevolution.com/marginalrevolution/2005/01/if_i_believed_i.html
   
   “>writing about the Austrian business cycle theory years ago. It’s pretty amusing reading it now.

   Ooops, all the predictions he ascribed to the Austrians came true!

   December 28th, 2008 at 2:43 am PST

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9. a writes:

   “The obvious answer is that when there is a boom, entrepreneurs know into what sector resources must be reallocated, and pull already employed workers from existing jobs into the new big thing. ”

   Might it be, that during a boom, workers are more fungible? Take real-estate during the boom. Basically anyone could sell real estate or become a loan officer, so it is easier to switch labor into “boom” sectors. In a bust, workers are less fungible, because there is no more “easy money”.

   December 28th, 2008 at 3:54 am PST

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10. Anon writes:

    Steve, great post as usual. The “free rider” problem with indexing is ignored far too often. If 99% of investors followed Jack Bogle’s advice and indexed, we’d be outsourcing all our investment decisions to two groups:

    1. The S&P 500 Index committee, other index providers, who at least have the benefit of low turnover and fees;

    2. The remaining 1% of the market still looking for mispricings and inefficiencies. Since that group is unlikely to be right 100% of the time — or even more than 55% of the time — then THEIR moves of better buying and better selling, moving prices, moves the ENTIRE market.

    While I don’t think we even get to this reductio ad absurdum, we have been trending that way, as you mention. Capital markets investors over-diversifying and indexing because they’re “too dumb” may eventually repeat the “conglomerate” mistakes of the 1970s’ corporate capital allocators/CEOs. Oil companies like Gulf+Western bought media assets to “diversify” when really they just were diluting their core competencies.

    December 28th, 2008 at 11:56 am PST

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11. RueTheDay writes:

    Krugman has a couple of good points in his critique of “hangover theory” – it’s difficult to argue that allocative efficiency requires unemployment during a bust but not during a boom and also that it’s impossible to ignore the fact that recessions generally create unemployment across the board, not just in the boom industries. However, he’s completely missing the boat in assuming that booms (or at least steady growth) can be sustained forever through the right combo of monetary and fiscal policy.

    I disagree with your comment on economics needing more “morality”. Whose morality is needed? Aristotle’s? Plato’s? Kant’s? JS Mill’s? Ayn Rand’s? You’ll need to define “morality” first before we can talk about whether we need more of it.

    If anything, we need to purge economics of morality. Hangover theory can be analyzed in a completely amoral manner. You mentioned Minsky (one of my favorite economists) so we can start by looking at the situation with a simplified Minskyan framework:

    — Financing is a necessary precondition for investment which is a necessary precondition for additional production.
    
    — A large portion of financing takes the form of debt.
    
    — Debt is a contractual commitment to make future payments denominated in nominal (rather than real) terms.
    
    — Firms assume debts today based upon the cash flows (profits) they anticipate their investments will yield in the future.
    
    — The future is uncertain and expected cash flows may not materialize.
    
    — Debts must be serviced, even if realized cash flows fall short of original expectations.

    Define the bust as the period of time following the realization by firms that their ex-post actual profits are falling short of the ex-ante expected profits used in making the debt-financing decision.

    Now you have fixed debt service payments, and cash flows inadequate to meet them. Firms react by aggressively cutting costs (laying off workers, suspending new capital investment) to get economic profits back in line with debt service. Unfortunately, this reduces income to households (hey look, there’s that missing microfoundation, no assumption of sticky wages needed) which reduces demand for products, and in turn firms’ economic profits. Eventually (this is a dynamic rather than static process) balance sheets are repaired, firms begin making investments (in labor and capital) again, incomes rise and the boom begins (as Minsky would say, “debt financing is once again validated by economic profits”). There’s your theory of the endogenous business cycle. And it is very much a cycle. Unless, deflation sets in, in which case the nominal nature of the denomination of debt service creates a positive feedback loop and you end up in a depression.

    December 28th, 2008 at 1:15 pm PST

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12. john c. halasz writes:

    Different industries/business produce for each other, long “before” they produce for final consumption demand. And for the economy to reproduce itself, let alone grow, such infra-industrial production must be inter-sectorally balanced with the right ratios of reciprocal inputs. (A fallacy of the Austrians is that they depict this reproduction requirement as purely a market process, whereas the vertical integration of production supply chains/stages may or may not be mediated by market exchanges, “outsourced”, but the ratios and requirements of reproduction belong to the sphere of production as a whole, not to the sphere of circulation and exchange and the vagaries of consumption supply and demand. Oddly, they tend to refer to the most basic levels of production as “higher”, though that might make sense in terms of “higher logical type”. But reproduction is a continuous, recurrently adjusting process, not a matter of the temporal distance between production and consumption). Real economic growth, increases in the real, distributable surplus product, (i.e. the total product minus that which is consumed in the process of production), requires inter-sectoral balances be maintained, and when that occurs, the production process feeds back onto itself and becomes a healthy boom, (rather than a bubble). However real economic growth is primarily due to technical improvements in the sphere of production, raising productivity rates through renovations of capital stocks in terms of processes and products. Hence the ratios of reproduction are changing even as they are being realized. But there’s the rub. It is a matter of a reproduction schema and not a production schema, and the “value” of capital stocks is determined by their replacement costs, not their cost-of-production, (even as capital goods themselves are subject to the same dynamic of productivity-enhanced cost-reductions). Hence older capital stocks are being destroyed, even as newer stocks are being produced, and losses are being produced along side profits. (Profit would best be considered as revenue – (costs + losses)). So long as there are sufficient profits from the realization of renovated capital stocks through revenues from the sale of output to outweigh losses and so long as there is sufficient aggregate effective demand, the boom can continue and feed on itself. But it will also tend to outrun itself and its underlying technical limits, as both output and productivity increase, saturating available effective demand and straining the adjustment of inter-sectoral ratios. The real surplus product is distributed between wages and profits in inverse proportion, with profit being at least sufficient to finance replacement costs, and wages sufficient to sustain effective demand. Yes, effective demand is wage-based, since the capitalists, the wealthy investors are both a) too wealthy to actually spend their total income, and b) derive their income from the profits of invested capital stocks, which profits themselves determine the “value” of those stocks, such that any one individual could sell out his stake, but in aggregate such individuals can not, since they would be selling out to each other. (Of course, wealthy individuals can borrow against their capital stocks to finance further conspicuous consumption, but those are chickens that will come home to roost, as such debts will come due precisely when capital stocks diminish in “value” at the downturn of the cycle and the resale market itself takes a dive). That’s the blunt point of Kalecki’s dictum that “workers spend what they get, whereas capitalists get what they spend”: the consumption of the wealthy merely contributes to the very effective demand from which they derive their profits. Somewhere, ideally, there is an optimal ratio of distribution between wages and profits, a sweet spot, that would both sustain effective demand and provide sufficient profits for investment, but because of the dynamic of changing technical conditions and inter-sectoral ratios, that’s a moving target, which is only adventitiously attained. Further, since the main driver of the system is the realization of profits, increases in productivity will only belatedly and partially be redistributed into wage-based demand. (More emphatically, in the real world production is largely in the hands of market-dominating oligopolies, which seek to capture rather than distribute rents). Hence the very boom will generate the seeds of its own stagnation, as the gains in productivity and output outstrip available demand, which determines the value of capital, and as inter-sectoral adjustments stall because of bottlenecks and differential rates of change between sectors of the production system. Opportunities for further re-investment of profits dry up, and rates of profit, determining the “value” of capital, fall, due to an oversupply of investable funds. (And, needless to say, capital stocks can not be subject to continuous technical improvement, since their “value” must be realized in output, before they can be depreciated into losses). The general economic boom turns down into a bust with the endogenous build up of unadjusted disequilibria in the economy, disagregating the “value” of capital. Of course, the “boom” can be prolonged through further extensions of credit and profits “manufactured” through competitive speculative bidding up of financial assets prices, (which is actually an expression of falling real profits, since increased asset prices mean lower returns). But that phase is precisely a bubble, leading to mal-investments, distortions in price signals, mal-distribution of income, and widening real disequilibria, rendering the bust all the more severe.

    So the upshot of this account of the business cycle is, yes, there is a such a thing as investment/debt overhang. But it has its “origins” in the real productive economy and in the inevitable gap between it and the nominal financial economy, and it’s not a matter of “malinvestment”, but of all-too-successful investment and the re-adjustment processes they require. And the occurrence of a bust is not a matter of arbitrary liquidity preference, but of budget constraints intertwined throughout the economy, which, whether hard or soft, become brittle. The recession is a readjustment process, clearing out bad debt and failed investment and re-aligning sectors and re-consolidating (the management of) capital stocks, and, most of all, reconnecting output with (the distribution of} income. But it is emphatically not the case that good investments must be liquidated with the bad, nor that unemployment must be maintained to facilitate structural adjustment. Indeed, that the whole point of the term “credit crunch”, where it’s precisely the good credits that get called in, since lenders are loath to fully recognize the extent of their loses on bad credits, which is a dysfunction requiring intervention. And it is the gap between over-valued capital, (which can become sheerly fictitious), with increased output/productivity, and deficient wage-based effective demand, which is at the root of the downturn, such that devalued capital needs to be brought back in line with sufficient wage-based income, even as labor needs to be structurally shifted, for recovery to occur.

    December 28th, 2008 at 11:18 pm PST

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13. john c. halasz writes:

    since it is both the sensed presence of adequate demand and the pressure of wage-costs that motivates renewed investment in capital stocks. It’s doubtful, to me at least, that “private” markets alone and unassisted would bring about any timely recovery, rather than tending to adjust to a lower “equilibrium” of ouput to “conserve” capital. Both public regulation,- (since the excesses at the end of the boom likely will reveal new forms of market-failures, especially since markets have restructured and innovated in practices during the boom, leading to a need for regulatory catch-up), and public investment, both to maintain employment/demand, (since many sectors, though perhaps over-extended during the boom, remain sound), and to support and stimulate the discovery of new avenues of real capital investment. (Indeed, given both the high costs and uncertainties of long-run fixed capital investment and the permanent potential gap between increased output and lagging wage-based demand, I would see public investment in some degree continuously and not just cyclically needed).

    Where my roughly Post-Keynesian account of the business cycle differs from the likes of Krugman, the New Keynesian neo-classicals, is that I reject the appeal to “general equilibrium” as identifiable with the optimal state of the economy as a whole. To the contrary, long-run dynamic disequilibrium, due to the changing ratios of inter-sectorally balanced reproduction and the gap between increased output and lagging wage-demand renders the notion of a general equilibrium tendency moot, in my view. “Equilibrium” is an analytic device more than a constant reality, and the notion that all markets of whatever sort would clear simultaneously with respect to all other markets is a scarcely plausible fiction. (Indeed, due the the predominant role of oligopolies, the notion of competitively determined prices at the margin clearing markets at equilibrium is dubious, more the exception than the rule, and not a clear standard of value by which nominal prices could be identified with underlying values, since oligopolies restrain competition and set many prices through administrative and market-manipulative procedures. Hence it’s not clear that industrial markets simply “clear”, nor do largely fictitious notions of the “labor market” guarantee “clearing”. At any rate, the core neo-classical account of distribution as being determined by the “marginal products” of the “factors of production” has long since been shown to be logically incoherent as an account of the economy as a whole, which the New Keynesians know and ignore). If “general equilibrium” were anything more than an a priori assumption for an approach to analysis, then to be an applicable concept, it would have to specify criteria for when general equilibrium obtains and when it does not, other than ex post. (Indeed, I think that the GE assumption, which manages to rationalize any state-of-affairs as optimal, if it obtains, goes to accounting for why most mainstream macro-economists failed to foresee, let alone forecast, the current crisis, when many common-sense observers were well aware of the growing bubble imbalances and the impending potential for debacle). Rather than imagining that “general equilibrium” as a state-of-affairs that can readily be restored due to market-tendencies,- (as if production systems and their differing forms of constraints could be collapsed mathematically into models of market exchanges, since, while markets might stimulate and promulgate innovations in the production sphere, they themselves produce nothing and do not determine prevailing technical conditions, and as if different types of markets and different market structures were all subsumable into a generalized notion of markets),- I would see an economy as a complex tangle of interlocking feed-back loops between different organizations, with equilibria designating the constantly adjusting feed-back control mechanisms of the interacting organizations. If there is a booming, innovative sector of real capital investment, it tends to spill-over into other more conventional sectors, generating a “virtuous cycle”, (though perhaps a rolling spiral would be a better image), of positive feed-back between interlocking nodes, and sparking a generalized boom, so long as re-adjustment processes that maintain inter-sectoral balances are effective. When the sectoral innovation boom reaches its limits, together with any other innovation boom that it might have sparked in other sectors, (since the underlying technical possibilities that condition economic growth themselves tend to come in interlocking complexes, though there is no way, economically, to predict, nor guarantee such technical possibilities, or their constraints), then an increasing number of interlocking nodes start to spiral downward through negative feed-back, and a recession of one degree or another of severity starts to take hold, spilling over into other more conventional nodes, as diminishing demand stimulus reduces profits and imperils credit. Market “clearing” operations take hold, liquidating excesses from the boom, but also tending to enhance the concentration of capital and oligopoly power, sending the economy into a sub-optimal stagnation “equilibrium”, with any way forward unclear. The paradox here, if there is one, is that wage-income needs to be supported through re-distribution, even as capital “values” diminish, and new avenues of productive investment need to be discovered and opened up, even as diminishing capital “values” shrink from further investment, in order to retrieve still valid sectoral capitalization “values”. But I don’t think that such a problematic can be articulated in a GE framework, as mere “stablilization policy”, since it’s precisely the prior unstable “equilibrium” that has collapsed, and a new one that needs to be found. Which, of course, would re-start the business cycle all over again, to the point of its subsequent collapse. And then there is the inherent tendency of business cycles to increase the concentration of capital and oligopolistic market-power, which is precisely, through the capture of rents that valorize their capital positions, what tends to freeze up the required re-distributions and re-investments. (Which is why a firm regulatory hand is needed, to unlock such frozen rents. My own view is that banks need to be nationalized, re-capitalized through public funds, with insolvent ones quickly shut down, ailing, but solvent ones revived and solvent ones- mostly small community banks- let be, with senior bond debt correspondingly converted to equity, and capital requirements raised, with risk weightings tightened and reduced, thereby shaking out all the bad “assets”, to be pooled into a “good bank/bad bank” scheme and run-off, at the expense of prior equity-holders, followng which the “shadow banking system” can be taken down, against strengthen bank capitalization, and the whole financial system should be re-regulated and broken up, to eliminate the too-big-to-fail-or-succeed syndrome). Any conception of GE, which would leave oligopolistic concentrations of production/market power in place, (let alone their prolongation into political influence/power), without any countervailing public regulatory, fiscal, and investment policies, strikes me as a counter-productive rationalization of a declining status quo. On the other hand, “free market” fantasies, as resolving crisis tendencies, strike me as more ludicrous than malign. But at any rate, the core neo-classical attempt to reduce economic “value” to nominal prices, a version of positivism, strikes me as not only missing the crucial distinction between the sphere of production and the sphere of circulation, however cross-implicated they may be, but as biasing the whole account toward the financial, rather than productive, economy, by means of assuming a continuity of nominal prices between the two, rather than acknowledging an endemic gap.

    Just a few more stra
    y comments on the Austrians. I find the serious Austrians,- (as opposed to recent graduates of the Von Mises on-line Bible college, and self-righteously libertarian, rather than classically market-liberal, fantasists),- going back to Boehm-Bawerk, interesting, though completely wrong. Interestingly wrong, since they at least serve to bring up core issues. And I find myself in ironical agreement with certain of their narrowly-tailored points. But it’s nonsense to claim that all-our-woes are due to fractional-reserve banking, (since that was baked-into-the-cake long before the rise of industrial capitalism), or that “fiat-money” is the cause-of-our-doom, (since there’s nothing wrong with growing the monetary base in conjunction with the real economy, which is different from excessive credit). Such a talent for creating theatrical hysteria out of the epiphenomema of problems of underlying production is almost worthy of admiration. The idea that money ought to be a permanent store-of-value amounts to a metaphysical fantasy of eternal Being, whereas, in fact, all Being is temporal: there is a reason why it is called “currency”. In fact, money is only ever a semiotic instance, a representation of “value”, rather than the “thing” itself, and to imagine that gold or any other “hard” medium would not be so, is sheer fetishism. In fact, what qualifies a monetary medium is its uselessness, hollowness, its lack of substantial “value”, by which it can accrue “value” through exchange processes. And that there would be a “natural rate of interest” misses both that there is an on-going process of adjustments within the sphere of production, which doesn’t depend on interest rates, but rather interlocking production constraints, and that long-run real capital investment doesn’t depend on current interest rates, but on long-run returns through a variety of interest rate and business cycle environments, the returns on which, in turn, “pay” for interest rates. Neither a market-based “natural” interest rate, nor a manipulated one, suffice to fully resolve underlying problems of real productive capital investment, nor adequate distributions of returns to labor, (through the other interest rate channel of substituting debt-financed consumption for wage-based income). But most of all, the claim that our current woes are solely due to “fiat currency” strikes me as the height of fallacy. That the U.S., at the behest of its dominant oligopolistic interests, has been abusing its reserve currency status by running a dollar-kiting scheme, is not the fault of “fiat currencies”, but rather the fault of unchecked trade imbalances, which have been allowed, with symbiotic collusion with different interests of foreign developing countries, due to the influence of oligopolistic MNCs. That that might involve the interlinking feed-backs between much different economies with much different standards of “value” is not beside the point, but it’s more the result of real flows than nominal currencies,- and, at least, implicit deals between dominant partners. To wish such factors away, as much as to imagine that “free markets” would render them impossible, is to invert hard realities into the haven of a peculiar ideological utopia, one which imagines it’s tackling such realities, through its very “hardness”, by ignoring them.

    December 28th, 2008 at 11:33 pm PST

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14. Gu Si Fang writes:

    I think the ABCT deserves much credit for predicting and describing crises, including the current one. Yet I enjoyed reading Minsky’s book, which many keynesians would probably endorse. Three remarks come to my mind :

    1) Minsky does not question the fact that the boom is unsustainable. The main difference between his narration and ABCT is that he takes fractional reserve banking for granted. Under such circumstances, austrians claim that “financial markets” are inherently unstable, so it seems they agree with Minsky. Except that, for austrians, fractional reserve banking and central banking are part of what Mises called the “hampered market”, but not a “free market”. Is there more to it than disagreement on definitions? Minsky is no longer here to tell us how he thinks an austrian “free market” would behave.

    2) The second important difference between the post-keynesian and austrian stories is the distorsion of relative prices. This is not in the tradition of keynesian macro, and Krugman and others (including T.Cowen) seem to have a hard time wrapping their mind around it. This is reflected by the fact that the ABCT is often termed the “overinvestment” theory when austrians ask that it be called a “malinvestment” theory.

    3) I find that a good way to describe the austrian boom/bust is by thinking of it in terms of expectations. During the boom, monetary price distorsions make expectations drift away from their path. This is progressive and does not lead to unemployment. But the bubble is “unsustainable” which could be translated by saying that these distorted expectations are incompatible with one another (there is no way A’s plans can be executed if B’s plans don’t fail). The tipping point is when expectations get realigned – and this can be brutal – leading first to change of relative prices (e.g. drop in asset prices) which can the be followed by a shift of ressources according to the new expectations and prices. For these new preferences to be discovered and diffused takes time, during which there is unemployment.

    It is sad to note that Krugman never addressed any of those points seriously.

    December 29th, 2008 at 3:27 am PST

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15. RichardHSerlin writes:

    Steve,

    I know you like this idea of lots of small democratic investors using their individual knowledge and voting the price of individual stocks with weight based on the value of the shares they purchase, but this is a very dangerous idea. It’s like saying let’s have everyone in the U.S. vote on diagnosing that lump on your neck, rather than undemocratically having only a group of doctors do it who have studied such things intensely in school and on the job for decades, and have spent a lot of time carefully reviewing your x-rays and tests.

    Laypeople have little or no training for pricing individual stocks, and it takes years of training not to make big and common mistakes, and they have very little time to study the companies. They have other jobs and that takes a huge amount of time to do well.

    You really don’t want huge numbers of uninformed laypeople spending substantial percentages of their money on single stocks. It’s very dangerous for them, and it’s going to make stock prices far less efficient, far less reflective of true values.

    And it’s not like the skilled investors at the margin will just bid the prices all the way back to their true values. They don’t control a high enough percentage of national wealth, and there are a lot of other problems with that, well established in academic finance. One of the much lesser known, but very large ones, I pointed out in a 2006 letter in the journal Economists’Voice (by the way, edited by Brad DeLong and Joseph Stiglitz):

    
    One reason which was missing, at least
    
    explicitly, and which I have not seen yet in
    
    the literature, at least explicitly, is that a smart
    
    rational investor is limited in how much of a
    
    mispriced stock he will purchase or sell by
    
    how undiversified his portfolio will become.
    
    For example, suppose IBM is currently
    
    selling for $100, but its efficient, or rational
    
    informed, price is $110. It must be remembered
    
    that the rational informed price is what
    
    the stock is worth to the investor when added
    
    in the appropriate proportion to his properly
    
    diversified portfolio of other assets. Such a
    
    savvy investor will purchase more IBM as
    
    it only costs $100, but as soon as he purchases
    
    more IBM, IBM becomes worth less to
    
    him per share, because it becomes increasingly
    
    risky to put so much of his money in
    
    the IBM basket. By the time this investor has
    
    purchased enough IBM that it constitutes 20
    
    percent of his portfolio, the stock may have
    
    become so risky that it’s worth less than $100
    
    to him for an additional share.
    
    At that point he may have only purchased
    
    enough IBM stock to push the price
    
    to $100.02, far short of its efficient market price of $110. Thus, if the rational and
    
    informed investors do not hold or control
    
    enough—a large enough proportion of the
    
    wealth invested in the market—they may not
    
    be able to come close to pushing prices to the
    
    efficient level.
    

    December 29th, 2008 at 7:28 am PST

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16. br writes:

    The Krugman blog entry is indeed painful to read. Here is the
    
    winner of this year’s Nobel Prize acting, all-too-convincingly,
    
    as if he does not understand what money is and how it works.
    
    And, bless him, tossing out a kind of downscale metaphor,
    
    ‘hangover’ (the deserved headache from last night’s party) to
    
    take the place of truths about credit, credit expansion, the
    
    amplificatory properties of the regular techniques of finance,
    
    and the markets. Krugman is pretending, I suppose, that ‘he just
    
    can’t see what the problem is – except maybe the bad attitude and
    
    moralizing foolishness of those negative guilt-ridden unhappys
    
    over there.’

    If he is not pretending, we are all in deep. But even if the
    
    pretense is proposed to do us some good, one has to wonder
    
    whether indeed it could possibly be helpful and useful. My own
    
    answer is that the pretense just becomes a further part of the
    
    problem.

    For whatever else it might be worth, Mr. Halasz’ post above is
    
    difficult to read (organization into paragraphs can help one find
    
    his way through a screenful of text) but it is quite right in so
    
    many of its points. It is not the same language I would have
    
    used, but the ideas that money is representational and that the
    
    construction of the representation is accomplished in the society
    
    by processes that have fundamentally asymmetric properties are
    
    exactly right to my mind.

    “… a vice of Keynsians is to underestimate the role of
    
    information.” Hear, hear! Judging by Krugman’s post, that
    
    appears to be painfully true. One wonders if there is a way to
    
    get Krugman to calm down and think about what he is
    
    suggesting — and why it ends up being part of the problem.

    December 29th, 2008 at 9:28 am PST

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17. Kodjo writes:

    Lovely point about investing in the market rather than narrowly.

    December 29th, 2008 at 9:58 am PST

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18. JIMB writes:

    Steve – Hangovers result from booms driven by credit. Simple example: a past government finances pyramid building with printed cash only later to find a food shortage from bidding away labor from food. The printed money did not represent real savings (i.e. food stored).

    Then there’s going to be a depression as numbers of people lose their income when this fiction is found out. Food is tight. Whether the result is inflationary or deflationary depends on leverage and the knock-on effects.

    I am of the radical opinion that a great number of the rich don’t even pay taxes … their entire income is stolen funds. The government gets a cut of the stolen funds. This is from attaching themselves to the non-productive acts of money creation. Finance and Wall Street needs to shrink by 50% “Mortgage banking” needs to shrink by 75% to get back to sound lending (I ran an analysis of loans since 2002. Only 13% qualify under sound lending standards).

    So far, finance has soaked everyone else to hold it up. Which is why I believe it is a loser career at this point (having been in the business for 20 years now).

    To be sure there are many rich people that deserve their wealth that actually do produce wealth. I’d like to get back to finding out who they are. My view, let the contraction play out. Get the wealth drainers off of everyone’s back. Put Krugman into honest work, sweeping the street.

    December 29th, 2008 at 12:43 pm PST

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19. Richard H. Serlin writes:

    Let me put it another way; if you encourage laypeople to buy single stocks, what information are they adding? It’s true that some laypeople may have a bit of good useful, unique, individual information here and there on a company, but on average it’s going to be microscopic per person. And it’s not just that microscopic bit of good information that will be imputed in the price, it’s also bad information and bad analysis from the layperson that will be imputed in the price, that’s gigantically larger.

    The ratio of good signal to bad signal and random noise is minute. This is going to hurt the accuracy of stock pricing far more than it will help it, just like having laypeople vote on diagnosis and treatment of cancer, rather than trained doctors, who have spent a lot of time studying the patient’s data, is going to increase the probability of serious illness or death — greatly — not decrease it.

    This is not a situation like where you want the market of regular people to decide on what shoes are produced. That’s a situation where regular people have tremendous data and expertise — on what shoes are good for themselves. An individual is usually by far the best expert on what kinds of shoes he will enjoy the most. But he’s very far from the best expert on what the worth-it price of a stock is for him. There are so many common mistakes that would be made en-mass among laypeople.

    Most laypeople don’t even understand that obvious information will be, by and large, usually already reflected in the price. I don’t know how many times I’ve heard people say things like, “I think Wal-Mart is a good stock to buy because they’re so well run.”. It’s like saying I think a Honda Accord is a good car to buy because it’s so well made, without asking, yes it’s well made, but is it for the price? Is it if it costs $50/share and it takes 3,000 shares to purchase the car? No, it’s a horrible buy at that price. But even smart laypeople often don’t know that concept for stocks. It’s not that they aren’t smart; it’s just that they have no training and have never spent a lot of time thinking about it, and are already way to busy with other things to start.

    December 29th, 2008 at 5:57 pm PST

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20. Richard H. Serlin writes:

    One thing you might consider, rather than encouraging unqualified laypeople to pick individual stocks, is to put a tax on index funds. This would encourage more investing in funds actively managed by professionals with research staffs and budgets. It would provide a greater incentive for skilled professionals to analyze and value individual stocks and sectors.

    I don’t know if I would support such a tax, and at what level. I haven’t spent much time thinking about this, the pros and cons, and whether there’s a better solution, but I think it’s a lot better than encouraging unqualified laypeople to value individual stocks.

    December 29th, 2008 at 8:16 pm PST

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21. Lord writes:

    Few other industries are allowed to create money, but that is what the credit industry was doing by lowering lending standards and lending more to raise prices all on the back of leverage. The resulting debt has to be covered or written off through income, default, and inflation which takes time. Liquidity preference is high until then, to cover future losses as well as avoid them.

    I am not sure the tradeoff is diversification losing information as much as diversification to avoid the costs of acquiring information. The expense of acquiring and processing this information creates the concentration of advisors and means higher costs to avert it.

    December 29th, 2008 at 9:11 pm PST

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22. Mish writes:

    I discussed Krugman at great length in
    
    Krugman Still Wrong After All These Years

    and again in

    Yellow Brick Road Economic Theory

    Krugman relies on academic formulas just as does Bernanke.
    
    A bit of common sense is all it takes to refute Krugman

    Mish

    December 29th, 2008 at 11:09 pm PST

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23. Phillip Huggan writes:

    IDK the existing state of knowledge. Two things I can think of are you get diminshing marginal returns when credit is cheap as there is a time delay before new good business can submit a loan application and there is a time delay before you realize diminishing businesses are started to tank.
    
    Also, cash is a prerequisite for credit. A company that falls through its capital requirements and credit reserve ratios will fall even faster. A company that has a rising market cap or revenue is given the opportunity to borrow more. This is done on the basis of rewarding profitable companies but ignores the fact that there is a difference between lending to the same/better business model and lending to a marginally crappier model.

    December 30th, 2008 at 4:41 am PST

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24. Thomas Barker writes:

    You people have far too much time on your hands :-)

    To my (simple computer-science trained) mind – deflation is an increase in the value of monetary unit, inflation is a decrease in its value. These can logically happen independently of the quantity of money in-circulation. I could have a central bank stuffed with dodgy assets and collapsing credit markets, the currency would inflate [depreciate] as those assets soured, but the quantity of money could still fall. Similarly, I could print vast sums of cash to buy high-quality commercial paper, and the currency’s value would be stable even as the quantity explodes. (Real Bills Doctrine, I know.) The existence of a Central Bank w/ Fiat Currency system only makes sense if the State takes a view on the NPV of all the assets underpinning the banking system. In our case, this was left to S&P et al.

    The current behaviour of governments is so dangerous because they’re directing money back into “the bubble” or blindly into pet projects. We have less wealth than last year, the Asians simply aren’t sending as many plastic toys (and cars and computers and airplanes). Some assets are now screwed and need to liquidated, others are merely difficult to market. Important people need to start sifting through bank books to make these choices. It’s not a choice of “how much”, but “what”. Both monetarists and Keynesians seem to be ignoring the “what” bit.

    I’m currently going through the process of talking a wealthy friend out of withdrawing all his cash from the markets and buying farmland; having spent the last 4 years telling him to do the opposite.

    @Richard H. Serlin – Why do you hate index funds? There’s no evidence whatsoever they’ve caused or contributed to the bust. People usually invest badly because they’re blinded by greed or fear. How can that be worse for an index than for an individual stock? Would having more investment “professionals” really help???

    December 30th, 2008 at 9:18 am PST

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25. groucho writes:

    “I am of the radical opinion that a great number of the rich don’t even pay taxes … their entire income is stolen funds. The government gets a cut of the stolen funds.”

    JIMB, that’s the “Matthew Effect”. As the “Queen of Mean”(Leona Helmsley) so eloquently stated :”We don’t pay taxes. Only the little people pay taxes”

    December 30th, 2008 at 9:21 am PST

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26. Richard H. Serlin writes:

    Thomas Barker,

    I don’t hate index funds. In fact, I think they’re the best for laypeople to invest in when they buy stocks. It’s just that there is a bit of an economic free riding problem in that they benefit from the stock research of others who push stocks to prices closer to their true values, but they don’t pay anything for that research, which economically can cause it to be underprovided.

    In economics when there is a free rider problem caused by what’s called a positive externality, so that someone get’s a benefit for free, this can cause the benefit to be inefficiently underprovided. One solution is a tax to make people pay the true cost of the benefit. However, there can be problems with this solution too. In this case, I’m not sure if the pros would outweigh the cons, so I’m not sure if I would favor that tax anyway.

    December 30th, 2008 at 10:29 am PST

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27. RueTheDay writes:

    One additional point – I really dislike the term “malinvestment”. It’s one of those value-laden, deliberately vague terms that enables it users (primarily Austrians) to frame the argument according to their own definitions (and effectively bake the desired conclusion into the premises).

    The only possible “neutral” definition of malinvestment is investment that ultimately does not yield a return in excess of its economic costs. However, all investment decisions are made in the context of an uncertain future where returns cannot be known ex ante. Whether an investment will be good or bad is unknowable in the present.

    Austrians would like to define malinvestment as investment in areas that would not have taken place in the absence of central bank policies that lowered the interest rate below the natural rate. This seems to me to assume that returns are known ex ante. It also assumes the existence of a “natural rate of interest”. The latter point was central to the debates between Sraffa and Hayek. Sraffa demonstrated such a concept to be logically impossible, and demolished Hayek so thoroughly that Hayek essentially stopped writing about economics altogether afterwards.

    January 1st, 2009 at 10:09 am PST

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28. Charles Monneron writes:

    Regarding the “masses of innocents” : There are no innocents ! When a credit bubble has reached such proportion and duration, one has to be an ermit not to have benefited from it.
    
    University professors, and that includes probably Paul Krugman, certainly think that their salary increase and better amenities were because of their fantastic contribution to the advancement of knowledge. The sad reality was that it was mainly caused by the bubble (or Madoff pumped) performance of Universities Trust Funds and a student debt-fuelled inflation of university tuitions, two sources of wealth that are dissappearing quickly.
    
    Even “Doomers” or “thrifties” that knew all along that the bubble was going to pop and were switching to cash and selling their homes at the top are in a better financial situation than if the bubble didn’t happen (even if they were not shrewed market timers, lower economic output would have meant lower opportunities for them to save too).
    
    So the argument that “something” has to be done to relieve the “innocents” from distress is moot, because they are no innocents. This is true at an individual level, but also at a country level : “surplus” countries like germany or china are not entiltled to get their money back from their overseas investment in “deficit” countries.

    Another, actually related, point is that there is no such thing than a riskless investment in real terms. Therefore, however “incapable” an investor is considered, one cannot guarantee him/her that his/her saving is going to attract a return, whatever this return is (except -100% of course…).
    
    It therefore means that every saver has to take an investment decision and own up to its consequences. The less he/she will put work in the decision process (like “equity index fund are always better in the long term” or “housing can’t fall” or “one cannot loose real wealth by investing in treasury bills” memes), the lower his/her real return is likely to be . The point of “free banking” as advocated by the Austrians is that it accepts that fact by clearly informing that investor that purchase a bank bill will explicitely know the risk that they will not be repaid, and that investor that decide to put their funds in a commodity based currency deposit – 100% backed of course – will explicitely know the risk that the real value of their deposit can go down.

    Finally, regarding the Sraffa/Hayek controversy, it all boils out to the Keynesian fallacy of money as a store of value, something that again cannot exist because it would be a riskless investment in real terms (with zero interest, but still guaranteed capital). Hayek is right in pointing out that there is as many rates of interest that there are commodities.

    January 1st, 2009 at 3:00 pm PST

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29. Richard H. Serlin writes:

    Actually, I should be clearer, it’s not that laypeople who buy index funds don’t pay anything for the research done by others. By buying at prices that are at least somewhat less than optimal, they provide profit opportunities for those that do good research. The more they buy, the more profit there is available to the researchers. The thing is, there are still economic externalities that aren’t fully captured in this, and from that there is some free riding. The question is how much, how big. Big enough to be worth the costs of doing something about it?

    January 1st, 2009 at 7:21 pm PST

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30. BSG writes:

    RueTheDay – it seems to me you set up a straw-man. You don’t have to agree that massive creation of fiat money/credit out of thin air leads to malinvestments, but the idea is clear enough.

    Besides, you may want to check your facts. I believe the Hayek Sraffa exchange took place in the 1930s. Hayek published on economics for decades after that and, if memory serves he was awarded the Nobel Prize in 1974, long after he was supposedly “demolished.” You may want to look up his Nobel lecture – you might learn something.

    January 1st, 2009 at 11:44 pm PST

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31. RueTheDay writes:

    Charles writes: “Finally, regarding the Sraffa/Hayek controversy, it all boils out to the Keynesian fallacy of money as a store of value”

    Fallacy? It seems to me a self-evident truth. Money most certainly does serve the function of a store of value, as can be verified by simply observing human behavior. And as Keynes noted, during periods of economic uncertainty, people attempt to increase their precautionary balances of money, which has a marked impact on real economic activity.

    Of course, in order for Austrian theory to “work”, money MUST not be anything more than a medium of exchange. So the Austrians simply assume the conclusion they are trying to demonstrate.

    “Hayek is right in pointing out that there is as many rates of interest that there are commodities.”

    Umm, that’s what Sraffa pointed out, not Hayek. It renders the entire concept of a “natural rate of interest”, and thus Austrian Business Cycle theory which depends upon it, incoherent.

    BSG: Hayek published his last works on pure economics, The Pure Theory of Capital and Profits, Investment, and Interest in 1941. After that, he wrote about political philosophy, sociology, law, epistemology, and psychology. He may have touched upon economic topics in some of those later works, but he was no longer writing about economic theory.

    January 2nd, 2009 at 9:40 am PST

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32. JIMB writes:

    RueTheDay – Malinvestment is an observable fact. As far as being circular, all theories are circular … they all have to (ultimately) “assume” something. The question is, is that assumption demonstrably true? Is it a visible fact? That is where Austrian economic theory shines. It starts with human action (i.e. humans act to change their state of mind from a less comfortable one to a more comfortable one), and from that the law of demand is derived (people use goods available to them first for their most urgent desires and then second for their less urgent desires). From this, indirect exchange, and from that, relative pricing. Relative prices ** are ** affected by “printing money” so in that respect printing money is certainly going to induce more entrepreneurial mistakes than otherwise. In our case, the situation is made drastically worse by moral hazard. These conclusions are obvious, factual, observable.

    In my experience, most people that want to discount the theory want to do so because they want to run the show or want the government to run the show. For that I have one clear observation: If that worked Rome would still be here. Unfortunately, I think we are going in that direction, rather than in the direction of freedom, sound money, prosperity, and peace.

    January 2nd, 2009 at 12:37 pm PST

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33. Thomas Barker writes:

    I’m going to advance the notion that “functional” unemployment actual does rise dramatically during a boom.

    During the present boom many people:
    
    * Started loss making businesses with their own, or others, borrowed capital.
    
    * Went freelance working 1-3 days a week in inflated sectors (I’ve heard of a firm pay $7000 per “email broadcast”.)
    
    * Became “professional” landlords.
    
    * Cut their hours to pickup income support as unskilled salaries fell in real terms.

    Those people were unemployed in a literal sense, as they’d voluntarily exited the job market. They just weren’t looking for work, or claiming full benefits.

    Then you add in the malemployed [those who work in industries that generate and/or consume “fake” credits]. (I’d list some examples, but it’d only degenerate to a list of people better paid than me who do something I don’t understand…)

    Perhaps this is the true breaking point – where the fruppochino drinkers fail to produce enough goods to motivate the fruppochino servers – rather than any specific debt or capital level :-)

    This might help explain how the boom became so entrenched in the UK. We drew down Poland’s supply of engineers, mathematicians and lawyers into our fruppochino serving classes, preventing the need to balance fruppochino consumption and barristas… until the £ dropped… now they’re all going home!

    January 2nd, 2009 at 5:21 pm PST

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34. Killer writes:

    This is so you Thomas!

    -Bored Killer From Wales

    January 5th, 2009 at 10:49 am PST

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35. Yancey Ward writes:

    Charles Monneron’s comment is a truth that so many simply don’t understand and most of those who do are still trying to deny- there are few “innocent” Americans that didn’t profit from the boom in one form or another. The political calamity that is unfolding is a direct acknowledgement of this fact- almost everyone is due to lose some of this inflated wealth, but no one wants to. This applies to homeowners, stockowners, bondholders, government workers, service workers, manufacturing workers, etc. Almost everyone one of us profitted from the bubble and we are all cheerleading the politicians to protect our gains at the expense of everyone else. We are fools.

    January 5th, 2009 at 11:10 am PST

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36. Russell writes:

    “I don’t hate index funds. In fact, I think they’re the best for laypeople to invest in when they buy stocks.”

    1) Define “laypeople”.

    2) I invest in index funds precisely because the overwhelming majority of so-called “experts” are no better at predicting stock market moves than monkeys, especially ex ante.

    Many domains – particularly those dealing with social/economic phenomena – do not have true experts. Many domains are, however, dominated by the survivors (i.e., survival bias), or those who yell the loudest.

    January 6th, 2009 at 6:35 pm PST

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37. reason writes:

    I think Steve Keen is right here – what is missing from PKs story is any concept of a balance sheet. Debt really is the problem, not “misallocation” of resources. (I’m not sure I really understand that argument anyway, why can’t prices adjust in the meantime? For the debt story the problem is clear, people up to their eyeballs in debt aren’t helped by a wage cut.)

    January 7th, 2009 at 4:26 am PST

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38. reason writes:

    I guess I’m saying that the problem is not that people don’t know what they will spend a marginal dollar on next, it is that they don’t have the marginal dollar in the first place. Stop confusing a financial problem with a real one.

    January 7th, 2009 at 5:01 am PST

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