Krugman claims Austrians can't explain unemployment

Economics Economics Questions
21

I’m not going to lie, even though he speaks in a lofty and high and mighty tone and always derides Austrian economics, he has raised some good points in the past. I think people are incorrect to simply dismiss Krugman simply because “hes a lefty” and “with the media”.

As what was said before, during the boom there is an overall increase in the demand for labor. People’s time preferences haven’t lowered (in fact if anything they’ve increased) so they are demanding more consumer goods, and the consumer industries demand more factors of production (Labor being one of them) because they are expanding. At the same time, interest rates have fallen, so interest rate sensitive industries/projects are going to demand more factors of production (Labor). So there is an increase in the demand for labor everywhere, and the only unemployment that should really result, ceteris paribus, is frictional unemployment. Even then that will be low (“too” low for the natural rate of unemployment suggested by macroeconomists) because there is a fight for resources across time and wages are rising in order to give people incentives to take the jobs.

In an economy where true economic growth is taking place, people save more and decrease their consumption. Because people are buying less consumer goods, there is a decrease in the demand for factors of production (Labor) in those industries (Derived Demand effect). At the same time, however, interest rates have fallen, so investment industries/interest rate sensitive projects are demanding more factors of production (Labor) and so the unemployed workers can find jobs in those industries (Time Discount effect). Here, unemployment is more involuntary and resembles structural unemployment, the workers unemployed aren’t skilled enough for the open jobs in the economy. A drastic example would be store clerks are unemployed and can’t find work because the only jobs opening up are those of rocket scientists. However, while the store clerks might not be able to take the rocket scientist jobs, other people in the economy whose skills are closer to that of a rocket scientist but not as skilled will take those jobs (better pay, incentives, etc, just like anyone taking a job). Their job slots will open up and then the original unemployed workers can find work in those industries. It sounds a little akward when simplifying it into one example, but it really captures whats going on in a dynamic growing economy.

The only place where there is some difficulty between separating a bust from credit expansion and a stable economy where time preferences are increasing.

In an economy where time preferences are increasing, people save less and consume more. The supply of savings shrinks which leads to higher interest rates. The higher interest rates hurt industries and projects that are more capital intensive and interest rate sensitive. Now, what makes it somewhat similar to a bust is that with a higher interest rate and increased consumption, factors of production leave the investment sector in favor for the consumer industries. Certain investment projects that were thought to be profitable are no longer so because of the higher interest rate. Structural unemployment would result as workers are fired from jobs and get rehired by others, and in theory would be as painless as an economy reorganizing due to an increase in savings. Although people may argue that this will (depending on how you look at economic growth being “good” for an economy and higher time preferences “bad”) give society a smaller production structure, no one can deny that this can occur in a free market society.

What Austrians consider the original bust and recession from the credit expansion is the knowledge of the decrease in profitability in the investment sector and the shift of workers to the consumer sector. In a way, much like what was said above. However, at least in my opinion (or in anyone’s opinion for the Austrian theory to be correct) the switch to shorter production processes from a recession is markedly different than that of an economy simply experience higher interest rates because of the fact that the consumer industry doesn’t experience a corresponding increase in expansion after a bust. In an increasing interest rate society, consumption is increasing and is propelling a drive for expansion in consumer sectors and adequately absorbs factors of production from the higher sectors. While in a boom consumption is increasing, the corresponding bust causes business pessimism and psychological fear and decreased consumption initially which causes a decline in profitability in the consumption sector. If exacerbated, this can cause the Secondary effects of a Depression, which although is not considered the actual recession, it happens so frequently that it can’t be ignored.

In addition, during a boom consumption increases because of artificially low interest rates (The price, the “interest rate” is low enough to drive out people with higher minimum selling prices for their savings and instead to spend it on consumption). But when the misallocations become visible and the rise in the interest rate, people stop consuming as much. In short, the artificially low interest rates screw up investment and consumption, both are not sustainable. And so while there may have been underinvestment in the lower stages during the boom, there won’t be an similar “immediate” increase in expansion (like there would be in a increasing interest rate society) because of psychological negativity and flattening consumption. So the production structure will take more time to reorganize and can prolong the unemployment and may eventually lead to the secondary effects of a depression.

Krugman may have been hinting at something like that and may have never gotten his answer. Are the last three paragraphs (or any for that matter) correct and understandable? I know I’m not explaining the boom/bust cycle and everything in perfect length, but this is more or less what happens (or what should happen for that matter) in my view.

22

It’s sad that arguments on both sides (on most sides in economics it seems) are rhetorical and speculative rather than evidence based. It should be relatively simple to compare an economic freedom index to an employment level index and compare and contrast from that as a starting point…

23

Personally, I think Krugman is misunderstanding the Austrain argument, but it really isn’t his fault. Austrians spend so much time trying to “refute” Keynes it leaves the impression that their business cycle theory hinges on some aspect or fluctuations in aggregate demand. In reality, Austrian theory can be perfectly consistent with Keynesian theory because it isn’t about aggregate demand, its about aggregate supply.

Let me lay it out.

If you read some of Roger Garrison’s work, you will see that Austrians believe that spending on both investment and consumer goods increases during the boom and that this has a nasty consequence on the capital structure. Specifically, increased consumer spending leads capital resources to be shifted toward the late stage production of consumer goods, while at the same time, lower interest rates leads to capital resources being also shifted to earlier stages of production. Middle stages are neglected and capital there may actually depreciate without replacement.

In the end, we are left with a capital structure that is out of whack as resources are tugged to early and late stages of production. As Garrison puts it: " Outputs of earlier stages feed successively into subsequent stages. At some stage in this process, the viability of the policy-induced capital restructuring comes into question. Capital and labor resources complementary to those already committed to earlier stages are in short supply (Hayek, 1967, pp. 85-91)."

As result , we simply can’t produce as much as we used to produce until it brought back into alignment (the production possibilities frontier has contracted) and we have a recession. If you want to think about it another way (a way that Garrison does not use but makes sense to me), the amount of capital in the economy may have stayed the same or even increased during the inflationary boom.

But because the inflationary boom led to a realignment of the entire capital structure we no longer have the right KINDS of capital to produce the same amount of goods as before the boom. This essentially represents a productivity shock that reduces aggregate output. And this productivity shock will last so long as the capital structure is out of sorts.

IOW: If Austrians realized that they have more in common with Real Business Cycle Theorists and explained ABCT as such, Krugman et al would have a much easier time figuring it out.

24

This is a classic Keynesian style argument. Krugman doesn’t even address the Austrian understanding of the financial crisis directly (because the evidence is in our favor), but brings in a red herring of unemployment then ties it to the financial crisis.

25

W.H. Hutt in A Rehabilitation of Say’s Law long ago answered the unemployment argument. In fact, Luigi Einaudi, citing Machlup (while the latter was still purely Misesian), managed to in an essay entitled ‘My Plan is Not Keynes’s’, written just after Keynes books in the 1920’s and 1930’s, but prior to 1936 (yet which still applied even more so to Keynes 1936) to compress the reason for crises into two paragraphs, as well as dealing with unemployment therein.

26

Josh, I really like your post.

27

Indeed. One of the early critiques of the ABCT, which was rather good (but still invalid), is that increased investment (brought about by reduced market rates of interest) would actually increase the capital stock, which would push the natural rate down to the market rate, restoring equilibrium (but with an expanded capital stock; kind of like forced economic growth). The argument is essentially that the Austrian’s are correct, but they fail to see that inflation is actually economic stimulative, both in the short and long run. Now, it is true that some investments undertaken because of the artificially low interest rates will indeed be completed on time, which will increase the capital stock; but there are many more investments which cannot be completed at all, on time, or will be completed at the expense of other more warranted productions (once aggregate demand for consumer good rises, and puts upward pressure on market interest rates). Essentially the problem is the lengthy nature of production, and the fact that longer-term investments are especially sensitive to interest rate reductions. But the completed investments are not a problem, even if they were entirely contingent upon the artificially reduced market rate of interest.

I’ve been curious about real business cycle’s for a while.

28

Most economists which suggest real business cycles use:

differential equations to form a continuous model,

a typical homogenous capital,

a typical homogenuous consumer,

a typical time preference rate B,

an a single autoregressor to introduce a shock to the economy.

They do not consider government policy to be a shock. Only real shocks, i.e., technology errors cause business cycles in that model.

The autoregressor shock means rent spikes so first overinvestment relative trend on capital, then underinvestment for a longer time (capital consumption as in Hayek’s 1930’s article).

The autoregressor is X t +1 = p X t + U, 0 < p < 1, which is assumed stable with covariance(x t, X t + 1) tending to 0, and p determined empirically (this is apparently thought possible).

The positive technology shock eventually peters out, but effects of capital consumption remain (proper to detrended GDP).

IN SUMMARY:

RBCT provides some lip service to Hayek’s really early stuff, but nothing in common with ABCT

29

the lion,

Well, I have never seen a poll of what modeling techniques are most popular in the RBC literature, but I would point out that there is nothing about RBCT itself that requires that the assumptions you list be made. For example, the paper that effectively launched RBCT–Kydland and Prescott’s Time to Build paper–did not assume capital goods were homogeneous.
http://www.jstor.org/stable/1913386?seq=1

And a single google search revealed a paper discussing RBC models utilizing heterogeneous agents.
http://people.virginia.edu/~ev4n/papers/sje.pdf

I would also note that it is incorrect to say that RBC theorists do not consider government policy shocks. Its simply not true. RBC models can very easily show how unanticipated monetary shocks for example could lead to fluctuations in aggregate output. Anticipated policy shocks are a different matter. I’m sure you probably know that, but are just trying to describe RBC models in the most unflatteringly way possible.

Now, I am not saying that ABCT is a subset of RBCT. I am just saying that ABCT is more closely related to RBCT than it is to Keynesian theories, but its really somewhere in between both. I say that ABCT is closer to RBCT because in both the primary driver for a recession is a productivity shock. The only question is where the shock comes from. However, ABCT is also closely related to Keynesian theories because both posit that monetary policy can routinely lead to output fluctuations (and really the Keynesian models of aggregate demand are much more sophisticated and flexible than the ad hoc way Austrians deal with the issue but that is another discussion). Really, without the capital structure side of the story, Austrians are just Keynesians that don’t like math. So it is the capital structure story that distinguishes them.

PS*

Just a side note, it always cracks me up when people on this board complain about math or the silly the assumptions of this or that model. Its just a fact of life that we sometimes have to make simplifying assumptions when trying to understand complex systems. Even Austrians do this, but they sometimes forget because they rarely lay out their arguments in rigorous mathematical form. And thats really to their detriment.

Think about it this way. Math has actually improved the intellectual productivity of most mainstream economists for one simple reason–its made their arguments more explicit. 50 years ago, you could probably spend your entire career publishing papers reinterpreting things economists wrote 50 years before you. Some of these people are still around today, writing papers on what the General Theory “really means” or some such. But they’re a dying breed. Thanks to mathematics you are not left wondering what assumptions Milton Friedman or Paul Samuelson were making in this or that paper, because they were forced to spell it all out for you. IMO this is a hugely positive productivity shock because we are not spending time trying to understand each other. But that is an unrelated rant I want to spill.

30

That really must be a side note as it’s not grounded in anything theoretical because logical categorical forms truths don’t change either. But as long as everybody understands the mathematical symbols and categorical forms it is a way to communicate even after one is dead and gone. Language, ie. culture, is still a communication medium from generation to generation and era to era.

Oh, and I’m going to make a spontaneous decision in a few moments - math its content before I actually live it.

31

The system under investigation is not subject to mathematical description. The nature of the system under investigation cannot be modeled in any way or form according to the language of differential equations. The difference in methodology between Austrians and other schools is not due to a mere style or preference in modeling and describing complex systems. The difference stems from completely different assumptions about the nature of the system itself.

To talk about Austrian theory being modeled in the language of mathematics for simplicity or for clarity is the most damning indication of your ignorance in Austrian theory.

You mock what you don’t understand. Just like when you talk about capital theory. You cannot use differential equations to model Austrian theory. The subjects under investigation do not follow any such patterns that can be modeled by such equations.

You talk as if everything in the natural world can be described by such mathematics. Do you know how many complex systems in the field of engineering cannot be modeled by the mathematics of differential equations? I am tempted to say most of them. And Engineering is a very mathematically intensive oriented field. Way more then you can ever imagine if you are in the field of [mainstream] economics. Engineers have no problem in not using such mathematics when they are not appropriate. I guess because they actually have to deliver the goods, while you can rant on with your rubbish for an entire century.

32

I just read Kydland and Prescott’s paper. The model I presented is what is more recently presented as the Real Business Cycle Theory.

Government policy is not usually found to be correlated in any linear way to capital consumption and in most papers tossed out. Austrians say: of course, because it is related entirely nonlinearly via the Cantillon-Gossen demand effects and the Mises supply effects. Linear or quadratic or X # of dummy variables regressions won’t work.

In any case, please review the paper you posted again. It considers time and time-preference; true. John Hicks started that mainstream trend by partly siding with Hayek in the seventies. But capital is effectively homogenous in that model. The model says nothing about capital structure: how do I know?

I know: because I don’t see any vector math in the paper.

Vector math was misused by Leontief and Koopmans; but any truly heterogenous theory requires vectors. Just used in a different way. DD5 said it,

No vectors = no model of the Lachmann or Kirzner type. As of now, not such mathematical model exists. Thats too bad. However, verbal proofs are the next best thing at this time.

Thats how real science progresses; not by making models which are vague and saying they capture the statistic. Of course they do: the whole capital is a variable, where the coefficients are empirically fixed to ‘make it work’; so the test shows, then, after the model has been tweaked, that ‘it works’. Of course it does, given that definition of ‘works’.

Of course, the no-arbitrage condition cannot be used either (like von Neumann and Koopmans did to allow them to solve a purely technical nonmarket process. No-arbitrage is the goal, not the environment, as first Gossen, then Mises, Hayek, Lachmann, and Kirzner showed.

33

thelion,

“effectively homogeneous”? I don’t know what that “effectively” homogenous means. But I can tell that you do not treat capital is not considered to be a homogeneous good in this model. Specifically K&P are differentiating between capital goods that are currently being built and those that have been completed. In a model where capital is strictly assumed to be homogenous investment is seen simply as the creation of new capital goods and because all capital goods are the same, “new” capital goods are not different from “existing” capital goods and they add immediately to the economy’s productive capacity. K&P say “no that it isn’t true, it takes time to build capital goods, so ‘new’ capital goods are different from ‘existing’ capital goods–and a new capital good does not become part of the productive capital stock until it has been completed.” They are explicitly making distinctions between different types of capital goods and so by definition they are not treating capital as a single homogenous good. Check out Section 3 where the model is defined.

Now, you are right about one thing they do not explicitly model the capital structure in this model. They do in fact assume that there is a single type of capital in the “completed” productive capital stock (but because they distinguish between completed and incomplete capital goods you cannot say they treat capital on the whole as homogeneous). But I already noted that the Austrian emphasis on the capital structure was the ABCT’s distinguishing characteristic. So to me saying that the model doesn’t account for the capital structure is like saying “hey! this isn’t an Austrian model of the business cycle!!!”. Well you caught me!!! That is true. K&P are not Austrians.

34

Recessions are the result of both monetary and real factors. Any explanation which focuses solely on the real factors must explain why the price mechanism is inherently flawed, that is, its inability to coordinate production. Production is not guided by extremely intuitive entrepreneurs who have some sort of mystical connection to market demand conditions; it’s guided by the price mechanism. I don’t know too much about RBC’s, but if it tries to explain cyclical fluctuations without including monetary factors then it’s practically useless.

You have to consider credit as a non passive economic phenomenon.

Well of course. They use extremely simplified and absurd assumptions (a collapsed structure of production). Also, what do you mean by “ad hoc ways Austrian’s deal with the issue?”

Keynesians are just Austrians without a capital theory.

I never understood this. Austrian’s have no problem with using simplified assumptions; Bohm-Bawerk, Mises, Hayek, ect all used simplified assumptions in order to elucidate their theories. The problem is with absurd assumptions which have nothing to do with reality. Their models are theoretically untenable not because they use simplified assumption, but because they use incorrect assumptions, which is why they yield absurd conclusions. It’s that simple really. This is why Krugman praises protectionism, and why Mankiw praises negative interest rates.

And what about methods/techniques of production? You can have different types of capital, but the model is still flawed if it assumes that production techniques are constant; that is, that every addition of new capital merely adds onto the already existing stock of capital in the same way and in the same proportions.

35

Ignoring the capital structure or different production techniques in the model is only a flaw if it is important for explaining output fluctuations. Most economists think it is not. Austrians of course have a different opinion.

So I am not sure where this is going. If your only point is that RBC theorists are not Austrians, then I agree with you. I never said they were. I only noted that RBC and the ABCT share an important feature in common–they both explain business cycle through productivity shocks. And that if Austrians spent less time unecc criticizing Keynesian theory, and more time emphasizing this basic fact, people like Krugman would have an easier time understanding the theory as whole.

36

Student,

Let’s assume for the fun of it that you have a point on how communication would be achieved. For one, you’re assumption is that Austrian’s need to explain this point to Krugman or anybody else that might be involved in lab experiments on the market. Secondly, don’t you think if you figured this all out you could either bring that to krugman’s attention somehow since you seem to be the expert on the matter or krugman supposedly being a smart guy could have figured that out by now? Of course, there’s so many assumptions on who is to contact who almost like after a first date, but if anybody has to contact anybody I think it falls on your lap since you may have figured out something. Nobody needs to be your errand boy don’t ya think?

37

Well, I tried to explain all of this to Krugman when I was visiting him last month while he was on vacation. But man, the only thing that guy could focus on was taking body shots off Robin’s monster rack. Muy caliente.

38

lol… This thread might link up with the robot thread and the D/C comic thread soon enough.