Britannia Radio

Austrians Can Explain the Boom *and* the Bust

In a recent debate, prominent Keynesian professor and blogger Brad DeLong
claimed that the Austrian explanation of the business cycle "does not work
as an intellectual enterprise."[1] <http://mises.org/story/3387#note1>

DeLong quotes Paul Krugman who, back in December, apparently dealt the
Austrian diagnosis a crushing defeat on both theoretical and empirical
grounds.

In the present article, I will set the record straight. Krugman's
theoretical criticism of (what he dismissively calls) the "hangover theory"
of recessions is silly, and his empirical test is also a poor one. Once we
set up a more appropriate test, the "hangover" theory - i.e., the
Mises-Hayek explanation - passes with flying colors.
Krugman's Two-Pronged Critique of the "Hangover Theory"

On his popular *New York Times* blog, back in December, Krugman
lamented<http://krugman.blogs.nytimes.com/2008/12/27/hangover-theorists/>the
idiocy of his colleagues. He can't believe that John Cochrane would
say
something this (allegedly) foolish:

 "We should have a recession," Cochrane said in November, speaking to
students and investors in a conference room that looks out on Lake Michigan.
"People who spend their lives pounding nails in Nevada need something else
to do."

In response to such (apparent) nonsense, Krugman offers first a theoretical
objection:

 The basic idea is that a recession, even a depression, is somehow a
necessary thing, part of the process of "adapting the structure of
production." We have to get those people who were pounding nails in Nevada
into other places and occupation, which is why unemployment has to be high
in the housing bubble states for a while.

The trouble with this theory, as I pointed out way back when, is twofold:

   1. It doesn't explain why there isn't mass unemployment when bubbles are
   growing as well as shrinking - why didn't we need high unemployment
   elsewhere to get those people *into* the nail-pounding-in-Nevada
   business?

 Before dealing with Krugman's second (and empirical) objection, let's
handle this theoretical objection.
 <http://mises.org/story/3155>

You can't understand Austrian business-cycle theory (ABCT) unless you first
understand the Austrian view of the capital structure of the economy. In this
article <http://mises.org/story/3155>, I showed how Krugman was simply
incapable of grasping ABCT because he lacks a rich enough model of capital.
For those newcomers who are unfamiliar with ABCT, I strongly encourage you
to read the fuller discussion in the hyperlinked article.

For our purposes here, a brief recapitulation of the argument: In a market
economy, prices really serve a function; they are not mere appendages of
exploitative power relations, but instead market prices signal real,
underlying scarcity and help everyone in the economy adjust his plans in
light of reality. The interest rates on various loans also mean something;
they are not arbitrary.

In particular, the market interest rate coordinates the "intertemporal"
(i.e., across-time) activities of investors, businesses, and consumers. If
consumers become more future oriented and want to reduce consumption in the
near term in order to provide more for later years, what happens in the free
market is that the increased savings push down interest rates, which then
signal entrepreneurs to borrow more and invest in longer projects. Thus
resources (such as labor, oil, steel, and machine time) get redirected away
from present goods, like TVs and sports cars, and the freed-up resources
flow into capital or investment goods like tractors and cargo ships.

Now when the Federal Reserve *artificially* reduces interest rates below
their free-market level, it sends a false message to entrepreneurs. Firms
begin expanding as if consumers have increased their savings, but in fact
consumers have *reduced* their savings (due to the lower interest rates).
Businesses that churn out durable goods, such as furnaces, cargo ships, and,
yes, houses will find business booming, because these sectors respond
positively to low interest rates.

On the other hand, other sectors don't need to contract, because (unlike the
scenario of genuine savings) nobody is cutting back on consumption. This is
precisely why the Fed-induced boom is *unsustainable* - real resources have
*not* been released from consumer sectors in order to fuel the expansion of
the capital sectors. Because modern economies are so complex, the charade
can continue for a few years, with entrepreneurs cutting corners and
"consuming capital" (i.e., postponing necessary replacement and maintenance
on equipment) while both investment and consumer goods keep flowing out of
the pipeline at increased rates. But the music eventually stops, since
(after all) the Fed's printing of green pieces of paper doesn't
*really*make a country wealthier. When the Fed "cuts interest rates"
it isn't really
creating more capital for businesses to borrow; it is instead distorting the
signal that the market interest rate was trying to convey.

So, in this context, Krugman the Nobel laureate is confused. When the Fed
starts dumping wads of newly printed cash into particular sectors of the
economy, why does this foster a period of prosperity - however illusory and
fleeting it may be? Why instead doesn't the money drop cause millions of
people to get laid off?

I admit I feel sheepish even phrasing the question that way, but go reread
Krugman's blog post; that's what he's asking. The answer, of course, is that
businesses armed with newly printed Fed dollars must *bid away* workers from
their original niches in the structure of production. Obviously, this
process doesn't lead to mass unemployment. The workers *voluntarily
quit*their original jobs because the inflated money supply has allowed
a few
firms to offer them higher salaries. The Fed's injection of new money has
not *yet* distorted the whole economy, and so there is no reason for other
businesses to suddenly find themselves in trouble and lay off workers at the
beginning of the artificial boom.

In contrast, once the bubble has popped, many firms realize they are
embarked on unsustainable projects. They need to lay off their workers.
Unemployment goes up, and only as workers reluctantly accept lower wages can
they be reintegrated into the economy. On average, workers are earning less
during the bust period than at the height of the boom. This is because the
salaries and wages of the boom period were exaggerations of the true
"fundamentals" of worker productivity, and also because the fundamentals
themselves have been hurt due to the waste of capital during the boom
period.

In short, workers on average are not as economically productive during the
recession because the whole structure of production has been thrown out of
whack by the Fed's injections of funny money. It is much harder for workers
to switch jobs and take a pay cut versus quitting a job in order to take a
better one that pays more.

That's the simple explanation for why the Fed-induced boom sees low
unemployment, while the necessary bust experiences high unemployment.
The Housing Bubble Has Nothing to Do With Job Losses?!

After his theoretical objection, Krugman turns to the data to raise a second
objection to the "hangover theory":


   1. It doesn't explain why recessions reduce [employment] across the
   board, not just in industries that were bloated by a bubble.

One striking fact, which I've already written
about<http://krugman.blogs.nytimes.com/2008/12/22/southern-discomfort/>,
is that the current slump is affecting some non-housing-bubble states as or
more severely as the epicenters of the bubble. Here's a convenient
table<http://www.bls.gov/web/laumstch.htm>from the BLS, ranking states
by the rise in unemployment over the past year.
Unemployment is up everywhere. And while the centers of the bubble, Florida
and California, are high in the rankings, so are Georgia, Alabama, and the
Carolinas.

This is rather surprising, isn't it? Forget the Austrian theory; Krugman is
here saying that the bursting of the housing bubble doesn't help explain the
onset of the recession! But don't worry, Krugman's analysis is flawed;
you're not going crazy.

First, note that the BLS table Krugman links to looks at the over-the-year
change in unemployment (by state) from December 2007 to December 2008. Now,
is that really a good measure of whether the bursting of the housing bubble
has anything to do with the recession? After all, the bubble had well burst
by December 2007. So if the "hangover theorists" are right, you would expect
the connection between unemployment jumps and housing-price collapses to be
weaker the farther along you get from the bursting of the bubble.

In response to an email from a grad-school friend, I decided to check on the
relation during a time frame that more tightly captures the bursting of the
housing bubble. The OFHEO <http://www.ofheo.gov/hpi_download.aspx> has
quarterly data on home prices by state; I picked the top of the bubble as
the second quarter in 2006.

Then I picked the other variable to be the change in unemployment (in terms
of absolute point changes, not percentages of percentages) from June 2006 to
December 2008, which is available (though not in a very convenient form)
from the BLS <http://www.bls.gov/lau/>.

Armed with this data, I ranked the states according to these two criteria,
and looked at the worst 10 in both rankings. In other words, I looked at the
list of the 10 states that had seen the biggest percentage decline in home
prices since the 2nd quarter of 2006, and I also looked at the list of the
10 states that had seen the biggest jump in the unemployment rate from June
2006 to December 2008. The 7th through 10th slots on the two lists didn't
match up, but check out the worst 6 slots in both lists:
 Ranking of States By Point Increase in Unemployment Rate, June 2006 -
December 2008

   1. Rhode Island (+4.9)
   2. Florida (+4.8)
   3. Nevada (+4.8)
   4. California (+4.4)
   5. North Carolina (+3.9)
   6. Michigan (+3.8)

  Ranking of States By Percentage Drop in OFHEO Housing Price Index, 2Q 2006
- 4Q 2008

   1. California, -27%
   2. Nevada, -26%
   3. Florida, -22%
   4. Arizona, -16%
   5. Rhode Island, -11%
   6. Michigan, -11%


<http://www.mises.org/store/Politically-Incorrect-Guide-to-Capitalism-The-P360.aspx>

$22 $20 <http://mises.org/story/3387>

Note that North Carolina and Arizona are the only ones that don't match.
That seems like a very strong correlation. (Depending on how we frame the
problem <http://www.gene-callahan.org/blog/2009/03/math-puzzle.html>, the
chances of this matching occurring randomly are anywhere from 1 in 8,400 to
about 1 in 350,000.)
Conclusion

Brad DeLong and Paul Krugman continue to mock the Austrian explanation for
the business cycle, but their ridicule is based on their own deficient model
of the economy's capital structure. Moreover, Krugman's quick empirical
points turn out, upon closer inspection, to support the Austrian position.
Unfortunately, because DeLong and Krugman have so fundamentally misdiagnosed
the problem, their "solutions" are a recipe for further disaster.
 <http://www.mises.org/store/Human-Action-Study-Guide-P547.aspx>

Robert Murphy, an adjunct scholar of the Mises Institute and a faculty
member of the Mises University, runs the blog Free
Advice<http://consultingbyrpm.com/blog/>and is the author of
*The Politically Incorrect Guide to
Capitalism*<http://www.mises.org/store/Politically-Incorrect-Guide-to-Capitalism-The-P360C0.aspx>,
the Study Guide to *Man, Economy, and State with Power and
Market*<http://www.mises.org/store/Man-Economy-and-State-Study-Guide-P304.aspx>,
and the *Human Action Study
Guide*<http://www.mises.org/store/Human-Action-Study-Guide-P547.aspx>.
Send him mail <bob.murphy.ancap@gmail.com>. See his article
archives<http://mises.org/articles.aspx?AuthorId=380>.
Comment on the blog <http://blog.mises.org/archives/009704.asp>.

You can subscribe to future articles by this author via this RSS
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 Notes

[1] <http://mises.org/story/3387#ref1> DeLong's UC Davis debate against
Michele Boldrin is available
here<http://www.iga.ucdavis.edu/Events/stimulus-smackdown-can-deficit-spending-save-the-economy>.
DeLong's discussion of (what he calls) the "Marx-Hoover-Hayek axis" of
business-cycle theory can safely be joined at the 10:00 mark of the video.
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