Paul Krugman's "Great Leaps Backward" Post

Miscellaneous Current Events
, ,
1

Paul Krugman offers his take of Austrian Economics in regards to Robert Murphys Post “[The Importance Of Capital Theory](http://January 19, 2011, 9:49 am Great Leaps Backward I’ve been watching with sympathy as David Beckworth and Scott Sumner discover that their updated monetarism actually puts them on my side of the great ideological divide — cast into the outer darkness along with John Maynard Keynes and Milton Friedman. But what does the other side believe? Someone, I don’t know who at this point, sent me to this post by Robert Murphy, which is the best exposition I’ve seen yet of the Austrian view that’s sweeping the GOP — and I mean that sincerely, never mind the puerile insults aimed at yours truly. As regular readers know, I’m a stylized-example kind of guy, and Austrians tend to prefer lots of words instead; but in this case Murphy does offer a little story that is, in a way, a counterpart to my story about the baby-sitting coop (although my story was based on an actual real-world example). So what is the essence of this Austrian story? Basically, it says that what we call an economic boom is actually something like China’s disastrous Great Leap Forward, which led to a temporary surge in consumption but only at the expense of degradation of the country’s underlying productive capacity. And the unemployment that follows is a result of that degradation: there’s simply nothing useful for the unemployed workers to do. I like this story, and there are probably other cases besides China 1958-1961 to which it applies. But what reason do we have to think that it has anything to do with the business cycles we actually see in market economies? I’ve already pointed out the problems, both logical and empirical, with the claim that workers are unemployed because they have zero marginal product. But there are many more problems with the notion of a recession as a supply shock. A short sample: If inflation is a case of too much money chasing too few goods, why aren’t slumps associated with accelerating rather than decelerating inflation, as the supply of goods falls? Why is there such a strong correlation between nominal and real GDP? Why is there overwhelming evidence that when central banks decide to slow the economy, the economy does indeed slow? And on and on. Oh, and what evidence is there that the economy’s capacity is damaged during booms? Investment rises, not falls, during booms; yes, I know that Austrians take refuge in cosmic talk about the complexity of production and how measured investment may not show what’s really happening, etc., but where’s the positive evidence of what they’re claiming? The point is that the real world looks a lot like the one Keynes and Friedman envisioned, in which the demand side drives the business cycle. Why should anyone be determined to throw away 75 years of economic thought, to believe that these appearances are deceiving? Why the insistence on taking an intellectual Great Leap Backward? Well, at that point we’re into talking about the essentially political nature of this thing. Maybe another time. Update: In case you’re wondering, no, I haven’t changed my view of Austrianism. If I say it’s interesting, well, I’d say the same thing about the phlogiston theory of fire.).” What do you think?

January 19, 2011, 9:49 am

Great Leaps Backward

I’ve been watching with sympathy as David Beckworth and Scott Sumner discover that their updated monetarism actually puts them on my side of the great ideological divide — cast into the outer darkness along with John Maynard Keynes and Milton Friedman.

But what does the other side believe? Someone, I don’t know who at this point, sent me to this post by Robert Murphy, which is the best exposition I’ve seen yet of the Austrian view that’s sweeping the GOP — and I mean that sincerely, never mind the puerile insults aimed at yours truly. As regular readers know, I’m a stylized-example kind of guy, and Austrians tend to prefer lots of words instead; but in this case Murphy does offer a little story that is, in a way, a counterpart to my story about the baby-sitting coop (although my story was based on an actual real-world example).

So what is the essence of this Austrian story? Basically, it says that what we call an economic boom is actually something like China’s disastrous Great Leap Forward, which led to a temporary surge in consumption but only at the expense of degradation of the country’s underlying productive capacity. And the unemployment that follows is a result of that degradation: there’s simply nothing useful for the unemployed workers to do.

I like this story, and there are probably other cases besides China 1958-1961 to which it applies. But what reason do we have to think that it has anything to do with the business cycles we actually see in market economies?

I’ve already pointed out the problems, both logical and empirical, with the claim that workers are unemployed because they have zero marginal product. But there are many more problems with the notion of a recession as a supply shock.

A short sample: If inflation is a case of too much money chasing too few goods, why aren’t slumps associated with accelerating rather than decelerating inflation, as the supply of goods falls? Why is there such a strong correlation between nominal and real GDP? Why is there overwhelming evidence that when central banks decide to slow the economy, the economy does indeed slow? And on and on.

Oh, and what evidence is there that the economy’s capacity is damaged during booms? Investment rises, not falls, during booms; yes, I know that Austrians take refuge in cosmic talk about the complexity of production and how measured investment may not show what’s really happening, etc., but where’s the positive evidence of what they’re claiming?

The point is that the real world looks a lot like the one Keynes and Friedman envisioned, in which the demand side drives the business cycle. Why should anyone be determined to throw away 75 years of economic thought, to believe that these appearances are deceiving? Why the insistence on taking an intellectual Great Leap Backward?

Well, at that point we’re into talking about the essentially political nature of this thing. Maybe another time.

Update: In case you’re wondering, no, I haven’t changed my view of Austrianism. If I say it’s interesting, well, I’d say the same thing about the phlogiston theory of fire.

2

Here is a man without intellectual curiosity whatsoever.

3

Because price inflation has typically been close to zero. The closer it is to zero, the closer the correlation. At 0%, it’s an exact correlation, obviously. But there is historically a negative correlation between real GDP growth and price inflation with any CPI increases > 1.8% annually.

4

i think boettke sums up my feelings:

None of what I have said means that Krugman is wrong to demand answers of an empirical nature from those who put forth the Austrian perspective on boom and bust. Those following the Austrian approach need to answer Krugman…This is just the way of economic debate, and those of the Austrian persuasion ought to be able to persuasively respond to Krugman’s challenges, just as they ought to respond to the criticisms of Cowen, and Caplan, and Tullock, and Yeager, etc. As Deirdre McCloskey often stresses, empirical questions demand empirical answers, and cannot be answered philosophically.

http://austrianeconomists.typepad.com/

5

A clever guy like Krugman deserves someone more sophisticated than me, but I’ll give it a shot. As always, my comments in bold:

First 2 paragraphs are just talk, so we go straight to:

So what is the essence of this Austrian story? Basically, it says that what we call an economic boom is actually something like China’s disastrous Great Leap Forward, which led to a temporary surge in consumption but only at the expense of degradation of the country’s underlying productive capacity. And the unemployment that follows is a result of that degradation: there’s simply nothing useful for the unemployed workers to do.

It would be nice if actually read some AE, as opposed to making up what you think it says

I like this story, and there are probably other cases besides China 1958-1961 to which it applies. But what reason do we have to think that it has anything to do with the business cycles we actually see in market economies?

Two reasons. First, history bears us out. Read Americas Great Depression by Rothbard, and other works which show this. After all, the first requirement of equating AE with phlogiston is to actually know what AE says, right?

Second, you yourself, all you Keynesians admit it, though of course you don’t realize it. You admit that every bust has a boom that precedes it. You admit that every bust has factories etc. not working at full capacity. Which means [though you don’t grasp this point], that those factories should not have been built so large in the first place. They were built to supply a demand that doesn’t exist. So why were they built at all? The foolishness of the boom did that. Well, what’s going to happen to workers in those factories? They will be laid off. What’s not to understand?

I’ve already pointed out the problems, both logical and empirical, with the claim that workers are unemployed because they have zero marginal product. But there are many more problems with the notion of a recession as a supply shock.

Who said a recession is a supply shock [=an event that suddenly changes the price of a commodity or service]? A recession is when people get laid off because they had unproductive jobs. Where did you see anything different in Murphy’s article?

A short sample: If inflation is a case of too much money chasing too few goods, why aren’t slumps associated with accelerating rather than decelerating inflation, as the supply of goods falls?

The basic answer here is that all slumps have [price] inflation that accompanies them. They should all be called stagflations. The ones that don’t are “lucky”, in that demand drops so much more sharply [you should know that, as a Keynesian], because of the incredible unemployment that goes with them.

Are you saying that Argentina and Zimbabwe have high employment? Every country that has high inflation has high unemployment. The two go hand in hand.

Why is there such a strong correlation between nominal and real GDP?

First, let us agree that GDP just measures spending. That’s what it counts, how much money was spent. Nothing else. The use made of GDP to deduce growth is not what GDP measures. It is a deduction from GDP.

Now that we agree on that, we must agree that real GDP [=adjusted for inflation] must always be zero, as shown in this article.

Having agreed on that, we must agree that the numbers for real GDP that are non zero are just fiction. So you are asking why do some fictional numbers follow a pattern? Who knows, who cares? Maybe because they were invented for that very reason.

Why is there overwhelming evidence that when central banks decide to slow the economy, the economy does indeed slow? And on and on.

Where did you see that AE disputes this?

Oh, and what evidence is there that the economy’s capacity is damaged during booms?

The bust that follows, silly.

Investment rises, not falls, during booms;

Ah, Watson, but are the investments in the right places? No they are not. Which will lead to the bust.

The truth is, if you think “investment rises, not falls, during booms” is somehow relevant to a discussion of AE, then you have shown yourself completely clueless about AE. You missed the boat in Murphy’s parable, excuse the pun.

yes, I know that Austrians take refuge in cosmic talk about the complexity of production and how measured investment may not show what’s really happening, etc., but where’s the positive evidence of what they’re claiming?

Huh? AE says that investments are made in the wrong places. Like those factories that cannot work at full capacity once the bust comes [which a s a loyal Keynesian, you admit exist]. Or those dot.com stocks, or housing.

I’m not sure why you don’t get this, Paul.

The point is that the real world looks a lot like the one Keynes and Friedman envisioned, in which the demand side drives the business cycle.

On the contrary. In a Keynesian Friedmanian world, Zimbabwe would be the richest nation on Earth.

Why should anyone be determined to throw away 75 years of economic thought,

Awww, you know better than that, Paul. A silly argument like that was made against Copernicus, and Einstein, and every discoverer of truth.

to believe that these appearances are deceiving?

They are not deceiving anyone. Read Austrian books on economic history [with an open mind of course] and thine eyes shall be opened.

Why the insistence on taking an intellectual Great Leap Backward?

I bet that’s what Pravda wrote when the Soviet Union wanted to go back to Capitalism.

The rest of the article contains nothing of substance.

6

Ouch. Cowen pops in with a killer right hook (keeping with Murphy’s metaphor of this being like a boxing match). To explain the comovement between investment and consumption, Murphy and Garrison both rely on the notion that maintenance of capital in the middle stages of production decline. However, as Cowen notes, the evidence available seems to indicate that capital maintenance actually moves with investment and consumption (and represents only a small portion of GDP anyways…at least in Canada).

The most careful study I could find, based on Canadian data, shows that investment and capital maintenance move together in the same direction. This piece argues for countercyclical maintenance expenditures, but not on the basis of any actual evidence. In any case, how much is capital maintenance as a percent of gdp anyway? Here is one earlier Canadian estimate of about six percent. Will variations in that sum – with conversion time – be enough to support a consumption boom? With expanding capital investment, a full employment assumption, and a basic closed economy model? I doubt it.

Not good news. It will be interesting to see how Murphy responds.

PS* Simply saying “well, we don’t know if that maintenance was on the right kinds of capital” really won’t cut it in an academic debate unless you can provide evidence that would indicated that the capital being maintained was indeed not the correct kind.

7

The comovement of investment and consumption is actually a vital part of the ABCT. The entire point of a “boom” is that something is being done in excess - and according to Austrians that thing is the consumption of scarce resources. There’s a reason why Austrian economists have about three hundered billion metaphors regarding brick-laying for a house when there isn’t enough bricks to finish the house and all other kinds of shenanigans. The point being made is that an economy cannot expand its capacity for both investment goods and consumption goods without prior investment, which requires savings (the negation of consumption). Maybe if you read some Mises you could understand this.

8

Smiling Dave,

I think you really need to re-think some of your arguments in your post (both substanatively and sylistically, as I think implying Krugman is the dim Watson to your insightful Holmes is probably a bit much). But I just want to respond to one part in particular.

Who said a recession is a supply shock [=an event that suddenly changes the price of a commodity or service]? A recession is when people get laid off because they had unproductive jobs. Where did you see anything different in Murphy’s article?

I think Krugman’s description is perfectly defensable. If I am correct, Krugman is referring to the fact that Austrians claim that an artificial credit expansion will distort the capital structure and result in the economy not being able to produce as much as it could before the boom. This is the essense of a supply shock.

If I wanted to flatter myself (and I do), I would argue that Paul Krugman saw and was convinced by my description of the ABCT in the post I wrote criticising his Slate article. I will repeat it below so you can have a better idea of where PK and I are comming from (PS* he asked me to call him PK from now on).

Krugman is ignoring is the impact malinvestments have on the capital structure and how this impacts total output. If you read some of Roger Garrison’s work, like this essay, 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). As a result, the LEVEL of income falls 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.

https://forum.freecapitalists.org/t/response-to-krugman/10724/4

9

Student,

TY for your genteel reply.

Your post to PK Watson talked about a productivity shock. Is that the same as a supply shock?

In any case, it’s not what you call it, it’s what happens, right? So I’m willing to withdraw that particular piece you quoted until I know more about the formal language of economics.

10

krazy kaju,

as i mention in the post above, the important question is the kinds of investment being made. Austrians like Garrison would argue that an artifical boom will lead to the creation of new capital in the early and later stages of production, which would draw resources away from maintaining existing capital in the middle stages of production.

That is why if we thought ABCT accurately represented most recessions that we would expect capital maintenance spending to be falling in boom time relative to new investment. However, for whatever reasons, that apparently isn’t what the data are telling us.

That is bad news because that is the the essential part for how ABCT explains output fluctuations that differentiates it from other theories. If the economy was not left with less of the “right kinds” of capital at the end of the boom, then it could just as easily produce the same mix of goods it produced before. So workers and other resources would move back toward those industries without any recession needed.

Now that isn’t a silver bullet against ABCT. But it will be interesting to see how Austrians respond. I mean, at first I thought they could argue “hey, maybe maintenance on capital in the middle stages of production decreased but that was offset by an increase in maintenance spending at the early and late stages”. But that doesn’t make any sense. Why would depreciation suddenly increase for capital in those stages of production relative to the middle stages?

Anyways, interesting stuff.

11

Your post to PK Watson talked about a productivity shock. Is that the same as a supply shock?

In any case, it’s not what you call it, it’s what happens, right? So I’m willing to withdraw that particular piece you quoted until I know more about the formal language of economics.

I would say, depending on the context, all productivity shocks could be considered supply shocks, but not the other way around.

Productivity refers to the amount of outputs you can get from a given set of inputs (i.e. you become more productive when you can produce more with the same amount of inputs). If we ran out of oil tomorrow then we wouldn’t be able to produce tires or fake christmas trees or many other things (at least not like we do now) and we’d see a huge drop in output. But I wouldn’t call that a productivity shock. It would really be an “input shock”, because we now no longer have the inputs to produce those outputs.

By contrast, if by magic all the electronics in the economy suddenly were replaced by similar electronics from 2005, I would say that was a productivity stock. We would have the same amount of inputs, but we would not be able transform them into outputs as efficiently.

I would call both “supply shocks” because they both impact the “supply-side” of the economy (the production of goods and services).

12

In any case, how much is capital maintenance as a percent of gdp anyway?

I seriously do not understand why anyone would listen to someone who said the above ^^.

GDP is arbitrary.

13

"A short sample: If inflation is a case of too much money chasing too few goods, why aren’t slumps associated with accelerating rather than decelerating inflation, as the supply of goods falls? Why is there such a strong correlation between nominal and real GDP? Why is there overwhelming evidence that when central banks decide to slow the economy, the economy does indeed slow? "

does gibberish like this really mean anything? i hope Bob Murphy reads this thread before he debates Krugman so he knows what he’s going to be up against.

an Austrian debating this guy would be analogous to Steven Hawking debating a Rabbi from 2000 years ago about the origin of the universe.

14

Student,

You completely misunderstand the ABCT. The entire point isn’t that resources are being misused, it’s that they’re being overused. The ABCT by no means requires that any stage of production shrink into accomadating expansion of other stages - the entire point is that unbacked credit expansion funds new investment projects (the malinvestments) which aren’t sustainable for the very reason that they’re competing for resources from previously established investment projects. These malinvestments are discovered as soon as consumers get their hands on the inflated money and reestablish their time preferences. However, in the case of continual credit expansion, this discovery takes significantly more time than from a singular credit expansion, and during this discovery, overconsumption occurs as consumers gradually get their hands on the inflated money.

15

krazy kaju,

everything i said in my earlier post came out of my reading roger garrison’s work, though it could just have easily have come from bob murphy’s sushi story that paul krugman linked to in the OP. similarly it meshes very well with what critics like tyler cowen and paul krugman were saying about ABCT. so as best i can tell there is nothing really orginal about what i said nor should there be anything controvertial (as economists on both sides seem to share the interpretation).

and really nothing i said contradicts what you said. you mention “over use” and “over consumption”. think about what those terms mean (overconsumption compared to what?) . think also about how that consumption is funded (hint: its through what murphy calls capital consumption). i think that once you define for yourself the meaning of those terms you will find that we are saying the same thing.

anyways roger garrison has a lot of great online resources for better understanding these issues and how they relate to ABCT (he used to have a paper written toward intermediate undergrads that was especially great but it looks like he took it down). here is one article by him with excerpts that should sound familiar to you after reading my post.

The low interest rate that accompanies the boom phase of a credit expansion directs resources to the early stages of production. But at the same time, the increased demand for consumption goods is accompanied by an increased (derived) demand for resources in the very late stages. Resources are pulled in that direction, too. For a time both kinds of policy-induced misallocations can occur, as depicted as a double distortion of the Hayekian triangle. The misallocation of resources (both malinvestment and overconsumption) shown in Figure 2 corresponds to the economy that has reached the hollow diamond point along the adjustment path that extends beyond the PPF. The Hayekian triangle shows resources being allocated away from middle stages of production in both directions. This movement would translate into Strigl’s account of the unsustainable boom as increased consumption and increased long-term capital creation, both made possible, in part, by the undermaintenance of existing capital.

…

Not far [into the boom phase] the limits imposed by scarcity become increasingly binding, but the low rate of interest continues to favor investment over consumption. At this point it does matter that the investment community gets the new money first. Resources continue to be bid into the early stages, while production processes that were in their middle stages at the beginning of the expansion—and from which resources were being misallocated at point 1—now begin to yield a declining volume of consumables.

http://www.auburn.edu/~garriro/strigl.htm

16

If I am correct, Krugman is referring to the fact that Austrians claim that an artificial credit expansion will distort the capital structure and result in the economy not being able to produce as much as it could before the boom. This is the essense of a supply shock.

I think it’s a mistake to classify ABCT as either a “supply shock” or a “demand shock”. It’s both; it can especially be a demand shock due to the sudden mismatch of prices resulting from credit contraction (which represents a fall in aggregate nominal demand).

17

…everything i said in my earlier post came out of my reading roger garrison’s work

This doens’t have any bearing on what you said earlier (I actually would argue that ABCT is about a “misuse” of capital goods, not “overuse”—that’s why Mises was adamant about using “malinvestment”, not “overinvestment”), but I thought Garrison’s Time and Money was poor. I think he overemphasizes the importance of some type of cohesive modelling between different macro theories, and fails to explain the Austrian theory well enough. If you haven’t already (I don’ know if you have), Hayek’s work is better.

18

“Why is there overwhelming evidence that when central banks decide to slow the economy, the economy does indeed slow?”

Sounds like he understands that central banks create the Boom-Bust Business Cycle and because it is a proven method of creating the cycle, it should be continued. (As if this were a desired result!)

19

“Oh, and what evidence is there that the economy’s capacity is damaged during booms? Investment rises, not falls, during booms; yes, I know that Austrians take refuge in cosmic talk about the complexity of production and how measured investment may not show what’s really happening, etc., but where’s the positive evidence of what they’re claiming?”

Austrians do not claim that the economy’s capacity is damaged during booms or that investment falls during booms. Austrians claim that economic capacity is stunted in its growth by a rise in malinvestments. The man simply does not understand Austrian Economics at its most basic levels (my level). The positive evidence is called a “bust.”

20

johnathan, i’m the opposite. i greatly prefer garrison’s clarity of exposition. hayek really doesn’t have that clarity and i think that has led to a great amount of confusion about what the fundamental aspects of his vision of abct actually were. for example, garrison obviously believes that income and consumption should increase in tandem during a boom (and contract together during a bust) and he sees this as being totally consistant with hayek. by contrast, murray rothbard’s exposition of the abct predicts that that investment should rise relative to consumption and he also cites hayek (http://mises.org/rothbard/agd.pdf).

So I guess the real lesson i take away from my reading is that there isn’t one “austrian business cycle theory”, but multiple ones all sharing common roots. i think this is fair and not uncommon (there is really no such things as a singular “keynesian business cycle theory”). it just means one needs to be clear when discussing these issues and that really hasn’t been done i think.