“If one asks what substantive contributions [F. A. Hayek] made to our understanding of how the world works, one is left at something of a loss. Were it not for his politics, he would be virtually forgotten.”
This assessment was offered up late last year in the online magazine Slate by Paul Krugman, 1991 winner of the prestigious John Bates Clark Award.
A few weeks before Krugman wrote that, Gene Epstein, economics editor of Barron’s, profiled this Yale-bred, MIT-based economic theorist. Epstein’s article was largely positive and wholly respectful. But in a mildly critical tone, Epstein wondered if Krugman hadn’t committed an error of omission. His writings on recessions seemed to suggest that he knew little or nothing about Hayek’s theory of the business cycle, a theory built on the cumulative efforts of Carl Menger, Eugen von Böhm-Bawerk, and Ludwig von Mises. Krugman conceded that he wasn’t familiar with the Austrian theory.
One is reminded of the notorious episode in which John Maynard Keynes reviewed Mises’s Theory of Money and Credit, which was published in German. He faulted Mises for failing to offer anything original and then later remarked that when he read German, he understood only what he already knew. If we get our appreciation of Hayek through Krugman, we can credit Hayek for very little. Unlike Keynes, though, Krugman cannot invoke language as an excuse. Hayek did not get the Nobel Prize for his political views; he got it for his work on business-cycle theory. Why would Krugman not be completely familiar with Hayek’s contributions? Stay tuned.
Clearly not a follower of Austrian theorizing, Krugman is, if anything, a quick study. On the same occasion in which he denied Hayek any standing as an economic theorist, he launched a vitriolic attack on the Austrians and their “hangover theory” of recessions. “I regard [their theory] as being about as worthy of serious study as the phlogiston theory of fire.” Though he failed to identify the Barron’s article or its author as the spark that set off this firestorm, he was clearly reacting to Epstein.
“Hangover theory” is a term obviously intended to denigrate the Austrian account of the unsustainable boom. Yet it is descriptive of many—if not most—modern business-cycle theories. The idea that booms lead to busts as drinking binges lead to hangovers is at home in both Monetarism and New Classicism. Even our sophomore-level college textbooks feature a stilted version of the hangover theory. In the late 1970s, the analogy between the abuse of monetary tools and the abuse of illegal substances became so well understood in the financial world that the argument by analogy was nearly reversed. A memorable cartoon of the period showed a balding Wall Street banker having a heart-to-heart with his errant teenage son: “Think of it this way, Timmy: Taking drugs is kinda like increasing the money supply. . . .”
The Austrian hangover is unique. The misallocation of resources during the period of artificially cheap credit has the feel of genuine growth, but these good feelings are followed by bad ones. The commitment of too many resources to projects that will yield output only in the remote future has as its counterpart an undue scarcity of resources for producing output in the near and intermediate future. In time the misallocation becomes apparent, after which follows a period of liquidation and reallocation—in a word: a recession.
None of this is to deny that a sharp increase in money demand (or a collapse in the money supply) can seriously retard recovery—as certainly happened in the 1930s. But Krugman would have us believe that monetary disequilibrium is the whole story: People, for some reason, want to hold more money than currently exists. Accordingly, his solution is simply to print the money up and let them hold it.
Krugman’s view of recessions is best put in perspective by comparing it with the contrasting views of Keynes and Hayek. These arch-rivals of the 1930s were in agreement that the increase in money demand, the “scramble for liquidity,” was a secondary aspect of the downturn but in disagreement about what the primary problem was. Keynes thought it was investment demand, which in a decentralized economy is prone to collapse. Hayek thought it was malinvestment induced by shortsighted or politically motivated actions of the central bank. [Editor's note: See Richard Ebeling's article, p. 28.] Krugman elevates what both Keynes and Hayek saw as a secondary aspect to the status of the primary problem. And then, creating difficulties for the historian of thought, he attributes the high-money-demand theory of recessions to Keynes himself.
Presumably rejecting all hangover theories, Krugman pronounces the Austrian variety “intellectually incoherent”—largely on the basis of a telling question: “[How can] bad investments in the past require the unemployment of good workers in the present?” Krugman’s implicit answer: They can’t—and therefore we needn’t pay any attention to Hayek. (The question itself is a good one and is likely to find its way onto macro exams at Auburn University.)
Emphasizing the time element in the economy’s capital structure, a Hayekian would argue that investment involves the employment of resources in a particular sequential pattern. During the downturn, good workers are out of work because the capital they need to work with is in short supply, having been committed to long-term projects now in need of liquidation. Krugman’s response (“Well, fine. Junk the bad investments and write off the bad loans.”) is all too facile. His advice is well taken, but the market process that implements it is time-consuming. During the junking and capital restructuring the demand for much of the labor force (labor whose capital complement has not yet been recreated) is low. And low demand translates into unemployment—except under the decidedly un-Austrian assumptions of instantaneous wage-rate adjustment and near-infinite labor mobility.
Recognizing that in Austrian theory the unemployment is somehow related to capital restructuring, Krugman poses another question: “Why doesn’t the investment boom—which presumably requires a transfer of workers in the opposite direction [from short-term projects to long-term projects]—also generate mass unemployment?” Gottfried Haberler asked the same question in his 1937 book, Prosperity and Depression. The answer is that during the cheap-credit boom, there is a net increase in labor demand. And because of the low interest rate, many workers are bid away from jobs in the late stages of production and into jobs in the early stages. During the downturn, however, there is a net reduction in labor demand. As liquidation gets underway, workers are released from the higher stages and (eventually) reabsorbed elsewhere in the economy.
Both of these future exam questions have been answered by drawing on Hayek’s contributions. Significantly, both answers involve heavy doses of capital theory, which serves as the underpinning of the Austrian theory of the business cycle. One seemingly permanent effect of the Keynesian Revolution was to tear macroeconomics loose from these underpinnings. Today, capital theory simply has no standing in mainstream macroeconomics. Accordingly, Hayek has no standing in the eyes of Krugman and other modern mainstream macroeconomists. It is a pity.
—Roger W. Garrison
Department of Economics