Answering Krugman on Austrian Economic Theory

I still get the sense that Krugman truly doesn’t understand the Austrian position. For example, he asks, “Why is there overwhelming evidence that when central banks decide to slow the economy, the economy does indeed slow?” But because the Austrian theory says the bust occurs when the central bank backs off and allows interest rates to rise toward their “correct” level, this is hardly a problem. In fact, if central banks couldn’t slow the economy, as an Austrian economist I would be worried about my theory. Krugman also poses questions concerning (price) inflation rates and the connection between nominal and real GDP. But I think he is conflating the Austrian theory with a purely “real” business-cycle theory. Austrians understand that monetary influences can have real effects. To repeat, that is the very essence of the Mises-Hayek theory. Although most of Krugman’s objections are due to his unfamiliarity with the actual Austrian theory, I think one source of confusion came from the particular illustration I used in my article. First let’s set the context by quoting Krugman : “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?” First, I should say I’m glad that Krugman at least concedes that (his understanding of) the Austrian explanation both is theoretically possible and actually happens in the real world — coming from the guy who referred to it in 1998 as equivalent to the “phlogiston theory of fire,” this is progress! However, Krugman still doesn’t have quite the right understanding of the Austrian view of the “capital consumption” that occurs during the unsustainable boom. As I said above, on this particular issue the fault lies with the necessarily simplistic “sushi model” I used in the article that Krugman read . In that article, in order to make sure the reader really saw why Krugman (and Tyler Cowen) were overlooking something basic, I had the villagers boost their daily sushi intake even while they developed a new technology to help augment their fishing. So during their “boom,” it would have seemed to a dull villager that both consumption and investment were rising. In my fable, this was physically possible because the villagers neglected the regular maintenance of their boats…

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Answering Krugman on Austrian Economic Theory

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