His strictures against neo-Hayekian economics. It is the best refutation of investment-overshoot-plus-frictional-adjustment around. From BobbyK's Paul Krugman archive:
THE HANGOVER THEORY: Are Recessions the inevitable payback for good times? SYNOPSIS: The constantly occuring idea of helpful recessions is incoherent and faulty
A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the "Austrian theory" of the business cycle--a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire. Oh well. But the incident set me thinking--not so much about that particular theory as about the general worldview behind it. Call it the overinvestment theory of recessions, or "liquidationism," or just call it the "hangover theory." It is the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion.
The hangover theory is perversely seductive--not because it offers an easy way out, but because it doesn't. It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love.
Powerful as these seductions may be, they must be resisted--for the hangover theory is disastrously wrongheaded. Recessions are not necessary consequences of booms. They can and should be fought, not with austerity but with liberality--with policies that encourage people to spend more, not less. Nor is this merely an academic argument: The hangover theory can do real harm. Liquidationist views played an important role in the spread of the Great Depression--with Austrian theorists such as Friedrich von Hayek and Joseph Schumpeter strenuously arguing, in the very depths of that depression, against any attempt to restore "sham" prosperity by expanding credit and the money supply. And these same views are doing their bit to inhibit recovery in the world's depressed economies at this very moment.
The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand. Maybe excessive money creation or reckless bank lending drives it, maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. Whatever the reason, all that investment leads to the creation of too much capacity--of factories that cannot find markets, of office buildings that cannot find tenants. Since construction projects take time to complete, however, the boom can proceed for a while before its unsoundness becomes apparent. Eventually, however, reality strikes--investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover.
Except for that last bit about the virtues of recessions, this is not a bad story about investment cycles.... But... [w]hy should the ups and downs of investment demand lead to ups and downs in the economy as a whole?... [T]he key to the Keynesian revolution in economic thought--a revolution that made hangover theory in general and Austrian theory in particular as obsolete as epicycles--was John Maynard Keynes' realization that the crucial question was not why investment demand sometimes declines, but why such declines cause the whole economy to slump.... As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income.... [I]f people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods--implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?
Most modern hangover theorists probably don't even realize this is a problem for their story. Nor did those supposedly deep Austrian theorists answer the riddle. The best that von Hayek or Schumpeter could come up with was the vague suggestion that unemployment was a frictional problem.... But... why doesn't the investment boom--which presumably requires a transfer of workers in the opposite direction--also generate mass unemployment?...
A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time. Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it's not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?
The hangover theory, then, turns out to be intellectually incoherent.... Few Western commentators have resisted the temptation to turn Asia's economic woes into an occasion for moralizing on the region's past sins. How many articles have you read blaming Japan's current malaise on the excesses of the "bubble economy" of the 1980s--even though that bubble burst almost a decade ago? How many editorials have you seen warning that credit expansion in Korea or Malaysia is a terrible idea, because after all it was excessive credit expansion that created the problem in the first place?
And the Asians--the Japanese in particular--take such strictures seriously.... [T]hey are in trouble partly because they insist on making hard choices, when what the economy really needs is to take the easy way out. The Great Depression happened largely because policy-makers imagined that austerity was the way to fight a recession; the not-so-great depression that has enveloped much of Asia has been worsened by the same instinct. Keynes had it right: Often, if not always, "it is ideas, not vested interests, that are dangerous for good or evil."
Our current financial crisis might not be the best example to discuss about whether we really need to keep “that perfectly good productive capacity be left idle?” as the real world seems fairly OK, except for a growing stock of unsold houses; and the crisis is mainly related to the virtual world of investments that now with all their slicing and trenching and AAA rating just seem to have been an extraordinary sophisticated pyramid scheme that will slice a piece of the wealth of those that fell for it.
But what does Paul Krugman really want to say with his common sense sounding view of trying to avoid recession at any cost since a recession can only bring us suffering. Is he running for some elections?
I for myself would love to see that house price index fall as fast as it has to, so that those in their houses with their mortgages will then suddenly be able to afford a renegotiated mortgage; or that those many that needed a house can begin to afford it again; and so that the overhang can be cleaned up fast and builders start building again… instead of seeing the whole thing drag out over years with house prices falling .3% per quarter. And really, that was always what I thought at least the old Austrians were thinking about.
It is not the size of the bump-recession that matters the most it is its length. Would Krugman want his aching tooth pulled out fast or slow?
Posted by: Per Kurowski | August 28, 2007 at 10:59 AM
"Whatever the reason, all that investment leads to the creation of too much capacity--of factories that cannot find markets, of office buildings that cannot find tenants."
As a layperson, is there any studies I can look at to investigate this? Namely, the question of is this investment coming from external sources, from loans, from selling off stock, or is it coming from internal sources, like profit. Or are these two things functionally the same? Does the term investment count for both of them the same?
Posted by: Karmakin | August 29, 2007 at 11:07 AM