|Paul Krugman on the
Austrian Theory of the Business Cycle
Paul Krugman smears with a broad brush when he
condemns the Austrian theory of the business cycle as the "hangover theory"
(Slate, December 3, 1998). Does he intend to reject wholesale the
idea that artificial booms (and drinking binges) lead to busts (and hangovers)?
If so, he condemns much more than the Austrian theory of boom and bust.
Hangover theory would have to include Milton Friedman's and Edmund Phelps'
short-run/long-run Phillips curve analyses, Robert Lucas' monetary misperception
theory of the business cycle, and the conventional aggregate-supply/aggregate-demand
analysis that allows for an upward-sloping short-run aggregate supply curve
as well as a vertical long-run aggregate supply curve. Each of these theories
identify a critical self-reversing feature of the market process that is
set into motion by an expansion of the money supply.
The Austrians see a
strong family resemblance in all these theories of boom and bust but favor
the Austrian theory over the others on the basis of its plausibility and
its attention to institutional considerations. (Some underlying methodological
precepts that I pass over here keep the Austrian theory well anchored to
With a central bank
controlling the money supply, new money enters the economy through credit
markets and impinges in the first instance on interest rates. The competing
theories mentioned above all ignore this critical institutional detail
and focus instead on labor markets or output markets as affected by misperceptions
of the inflation rate—or on nominal rigidities that prevent wage rates
from being continuously adjusted in the face of a depreciating medium of
In the Austrian theory,
booms are artificial—which is to say, unsustainable—if triggered by an
artificially low rate of interest. During a policy-induced and hence artificial
boom, capital is misallocated—malinvested, to use Ludwig von Mises' term.
Individual businesspeople responding to the favorable credit conditions
set the macroeconomy onto a wrong course. Quite independent of price inflation
or misperceptions of it, the boom contains the seeds of its own undoing.
Malinvestment (Krugman is wrong in calling the Austrian theory an overinvestment
theory) means too many resources committed to early stages of production
projects, not enough left to see the projects through their final stages.
To expect businesspeople themselves to see this problem in advance and
abstain from participating in the (ultimately) ill-fated boom is to misunderstand
the very nature of a market process. The Austrians do not ignore expectations,
but neither do they pretend that expectations can wholly nullify at the
outset the market distortions engineered by the central bank. (In trying
here to set Krugman straight about the nature of the Austrian theory, I
find it necessary to defend the theory against the challenges of the Rational
Expectations school as well.)
To make the Austrian
theory seem implausible, Krugman (like Gordon Tullock and Leland Yeager
before him) has the Austrians blaming the entirety of the Great Depression—its
unprecedented depth and spirit-breaking length—on the preceding overinvestment.
In fact, the Austrians blame the downturn, or upper turning point, on the
preceding malinvestment. The Austrian theory is not a theory of depressions
per se; it is instead a theory of the unsustainable boom. In 1929
the Federal Reserve had "a tiger by the tail"—to use F. A. Hayek's apt
metaphor. Whether the central bank held on or let go, the boom was over.
Good times were about to turn bad. The Austrians have had lots to say about
the government policies that made the bad situation worse (the propping
up of prices and wages, the cartelization of industry, the Smoot-Hawley
tariff, further bungling by the Federal Reserve), but they have something
unique to say about how the situation turned bad in the first place. The
capital theory featured by the Austrians and, more pointedly, the policy-induced
discoordination of the capital structure are not to be dismissed lightly.
The Austrian theory of the business cycle deserves much more respect and
attention than it has been accorded.
Krugman would have us
scrap the Austrian theory and all other theories of boom and bust in favor
of a peculiar variant of monetary disequilibrium theory, a theory he sometimes
attributes—questionably—to John Maynard Keynes. According to Krugman, "A
recession happens when, for whatever reason, a large part of the private
sector tries to increase its cash reserves at the same time." The recession
can be avoided, then, by an accommodating increase in the supply of money.
It's just that simple.
I call his theory a
peculiar variant of monetary disequilibrium theory because the standard
bearers of this school—from Clark Warburton to Leland Yeager—have forcefully
argued that historically relevant mismatches between the supply and demand
for money have virtually always been attributed to a decrease in the supply
of money, not to an increase in demand. It is possible, of course, for
the demand for money to increase—as it might in the final throes of a waning
boom when speculators lose confidence in the ability of the central bank
to sustain the boom. That is, an impending bust can engender a liquidity
crisis. This instance of an increase in the demand for money certainly
needs to be incorporated into business cycle theory. But even Keynes recognized
the scramble for liquidity as a complicating factor, not an initiating
Simply positing an increase
in the demand for money, as Krugman does, is not a fruitful way to start
theorizing about business cycles. If excess demand for money were the whole
story or the essence of the story, things would be even simpler than Krugman
himself imagines. Modifying his theory of excess money demand to conform
to historical experience (in recognition that it is supply that falls,
not demand that rises), we get a truly simple reckoning of recession. The
Problem: the central bank has decreased the money supply. The Solution:
The central bank should increase the money supply.
Whatever their ideological
leanings, the Austrians will surely be forgiven if they see this
theory as less than satisfying.
Roger W. Garrison