Krugman advertises ignorance

ABCT Investing is based on the Austrian business cycle theory, so I become mildly concerned when others criticize the theory. I never become seriously concerned because I have learned over the years that most critics are unbelievably lazy. If they bother to read Mises or Hayek they do so through the lenses of mainstream econ and fail to understand what the authors are actually saying. 

The Social Democracy blog has posted a long diatribe against Ludwig von Mises, which I would normally ignore had Paul Krugman not advertised it. Krugman even gets wrong much of what the blog says, but the blog gets a few things wrong so here are my responses:

Natural rate of interest

The blog is right that the “natural rate” of interest doesn’t exist. Of course, neither does “equilibrium.” Both are theoretical constructs to help us think about economics. Wicksell defined the natural rate as the rate of interest in a barter economy. Interest would exist if we were forced to barter goods because interest is nothing but the opportunity cost of giving up the use of something for a period of time. Austrian economists picked up on the idea as a useful way to explain how interest under barter differs from interest using money. It’s a teaching devise. But if you don’t like it you can ignore it. It helps teach the ABCT, but has little importance to the working of the theory.

Mises and fascism

Like FDR, Mussolini advertised himself as a defender of free markets and an opponent of communism before he assumed power. Mises took him at his word and in 1927 congratulated him for defeating communism in Italy. However, like FDR Mussolini turned into one of the greatest enemies of free markets in the 20^th century. Mises did not foresee the sharp turn to the left that Mussolini took. 

The last two sentences of the Mises quote are “Fascism was an emergency makeshift. To view it as something more would be a fatal error.” Mises criticized fascism and communism consistently in most of his writing. 

No one claims that Mises was infallible. Keep in mind that the great Keynesian economist Paul Samuelson praised the USSR in the last edition of his bestselling economics textbook before the collapse of the empire in 1989. Samuelson claimed the Soviets would become wealthier than the US. Does Samuelson’s blindness to the faults of socialism mean we should ignore Keynesian economics? The author’s attack was ad hominem and he should know better. 

Business cycle

Krugman wrote:

First of all, as the blog tells it, von Mises, faced with the reality of depression, basically dropped Austrian business cycle theory...

Krugman is factually wrong. Mises never abandoned his business cycle theory. The Great Depression was the worst financial and economic crisis in the history of the US. The state had created the Fed in 1913 to end the typical depression of the 19^th century, but the Great D was several magnitudes worse than anything any economist had ever seen or read about. It went deeper and longer in the US than in any other part of the world, even though the US had tried Keynesian style state intervention long before Keynes wrote his famous book. 

Mises and Hayek wrote that their business cycle theory could explain the beginnings of the Great D, the primary depression, but did not explain the tremendous depth and length of it, which they called a secondary depression. Other factors had to be considered in addition to the Austrian theory, not in place of it. They correctly identified the problem of high real wages as a major factor. Later, Keynes agreed with Mises and Hayek and recommended using monetary policy to create inflation and drive down the real wages of union workers in order to boost employment. Even Krugman would admit that the whole point of the Fed creating price inflation today is to reduce the real wages of workers and goose employment.

The Great D was so bad that it took decades for economists to figure out what happened and most, like Krugman still haven't. Chief among the causes was the Smoot-Hawley tariff that destroyed international trade. Austrian economist Robert Higgs has written about regime uncertainty, the uncertainty caused by rapid increases in regulation by the state, as another major cause of the lack of investment. 

But Hayek had the best explanation in my opinion – capital destruction. Modern jobs require capital equipment. Few jobs exist for pure manual labor. The malinvestment of the boom, and the collapse in international trade, destroyed the value of a great deal of capital plants and equipment. It became worthless. Those who depended on that capital for jobs became unemployed. It would take more than a decade for businesses to save enough and rebuild new equipment in other industries before employment could come back. 

“The solution, then, for Mises was eliminating unemployment relief (presumably forcing the unemployed to starve and accept lower wages)...”

Of course, the author wants to paint all Austrians economists as heartless and wanting to see the unemployed starve to death. Another ad hominem attack. Keep in mind that wages were too high relative to consumer goods. Prices, especially of food, had fallen dramatically while wages had not. The author should understand that is the meaning of “high wages.” So if workers took lower paying jobs they would not starve. Their standard of living would remain what it was before the depression.

“How else could such suppression of trade unions be realistically achieved except by government coercion?”

Well, you could do as Keynes recommended: print money and create price inflation to reduce real wages.

“Whatever lowering of demand for labour that might have been caused by higher wage rates during the depression could have been overcome and rendered irrelevant by effective expansion of aggregate demand.”

So the author is saying that Mises is wrong because Keynes was right. That’s pretty much Krugman’s response as well. The author takes it for granted that 1) the state or Fed can cause aggregate demand to expand and 2) if such expansion was possible it would turn excessively high wages into normal wages. 

Of course, the debate between Austrian and Keynesian economics is whether #1 and  #2 work. Austrians say the economy doesn’t work that way. In fact, Austrians say that increasing demand for consumer goods is what kills the recovery. The author assumes his conclusion, another common fallacy with Keynesians.

The US tried Keynesian policies long before Keynes wrote his book, and they failed to end the Great D. See Robert Higgs for a debunking of the myth that WWII ended the Great D. The failure of Keynesian policies during the Great D should have resolved the debate. If not, the failure of Keynesian policies in the 1970’s and since 2008 should have shamed Keynesians. It seems they are beyond shame.

“Mises was blissfully unaware of what many economists were to discover in the 1930s and what Gardiner Means had already discovered: that real world price rigidities are mainly caused by the private sector itself, because most businesses adopt relatively inflexible mark-up/administered prices.”

Mises was not ignorant of private sector price rigidities. The author would understand Austrian economics if he would not take the attitude from the beginning that Mises was just stupid. After all, Hayek won the Nobel Prize largely for his advances of Mises’ business cycle theory. All Mises said was that a large part of the price rigidity came from taxes and regulations. Businessmen can easily overcome their self-imposed rigidity, but they have no power to overcome the rigidities caused by the state.

“The type of price setting required by Mises’s economic theory is largely shunned by the private sector itself, so that the price flexibility Mises thought would clear markets cannot be attained.”

The author is blissfully ignorant of the history of prices in the world up to the Great D. Mises wasn’t. They were very elastic until the state made them inelastic with stupid policies, taxes and regulations.

“Even though many nations saw price deflation in the Great Depression, even in the 1930s mark-up prices were significant and relatively inflexible as compared with other markets...”

So after proclaiming that businessmen prevent prices from falling, the author has to explain why prices fell in the Great D. Of course commodity prices fell more than retail. Prices have always done that. Still, they fell, which makes the author refute his own comment. Retail prices may not have fallen as much because wages remained so high. But commodity prices always fall a great deal more because they supply the capital goods sector, and according to the ABCT, the capital goods sector, not the retail sector, gets hit the hardest in every recession. The latest recession was no exception. The blog author would know that if he would actually learn Austrian economics.

“For if debts remain fixed and wages and prices fall (or even more disastrously if wages fall but prices are less flexible), then it is likely that debtors will face severe problems as their burden of debt soars, and most probably deflation will induce bankruptcy of debtors and then bankruptcy of creditors and banks.”

So the author thinks no businesses went bankrupt in the Great D, or in the Great Recession? Businesses that borrow too much, and banks that make too many high risk loans, are supposed to go bankrupt. That’s how the market gets rid of bad businessmen and rewards good ones. It’s how efficiency increases and our standard of living rises. 

If businesses need inflation to survive and pay their debts, they’re bankrupt. Letting bankrupt businesses go bankrupt is how the market frees up capital that was badly invested in boom so that entrepreneurs can put it to better use. Keeping failing businesses alive through price inflation ensures a zombie economy like that of Japan for the past 20 years. 

The obvious contempt that the author has for Mises and Austrian economics guarantees that the reader will never get an honest perspective on the theories. The reader might want to check out the writings of economists who earned their PhD’s in Keynesian economics, taught it for decades, then came over to the dark side of Austrian economics. One is Robert Higgs and another is Deirdre McCloskey. Robert Borio of the Bureau of International Settlements promotes Austrian ideas.