Monday, January 31, 2011

Murphy's Response to Paul Krugman

Very few people liked to be publicly criticized. One of the blessings, however, of having to answer pointed questions criticizing our perspective is that it forces us to reexamine our position and, if sound, to find a better, more clear and ultimately more convincing way to present our case. That is the thought that came to mind last week upon reading Bob Murphy's excellent response to Paul Krugman's criticism of Murphy and his exposition of Austrian business cycle theory.

It is quite possible that you have read it already, but in case anyone had not, I want draw your attention to it. Although Murphy's piece is a direct response to Krugman, it also proves to be an excellent introductory summary of Austrian theories of capital and business cycles. There are a number choice parts of Murphy's response that I will highlight as follows:

Murphy begins his essay with an introduction on Austrian capital theory in which be links to an article about Austrian Capital in which he uses a formal mathematical model in his exposition, just to show Krugman his bona fides. This is an excellent rhetorical disarming of the standard tiresome criticism of Austrian economists not knowing any math.

In a section on the Austrian theory interest, he explains why savings and investment is necessary for economic expansion.
How is it possible that the community as a whole can have more income in, say, 30 years? Obviously the households think it is financially possible, because their bank balances rise exponentially with the higher savings rate. But technologically speaking, this is possible because the composition of physical output changes. The households have cut back on going out to dinner, buying iPods, and so on, in order to double their savings rate. This means that restaurants, Apple stores, and other businesses catering to consumption will have to lay off workers and scale back their operations. But that means labor and other resources are freed up to expand output in the sectors making drill presses, tractors, and new factories.

In 30 years, the economy will be physically capable of much higher output (including the production of consumer goods), because at that time, workers will be using a larger accumulation of capital or investment goods made during the previous three decades. That is how everybody can have a higher standard of living, through savings.
He then presents an excellent summary of Austrian business cycle theory. He explains why, when governments try to fund investment with monetary inflation without an increase in voluntary savings, this sets in motion an unsustainable boom that must resolve itself in recession.
Unfortunately, at some point reality rears its ugly head. The central bank hasn't created more resources simply by buying assets and lowering interest rates. It is physically impossible for the economy to continue cranking out the higher volume of consumption goods as well as the increased output of capital goods. Eventually something has to give. The reckoning will come sooner rather than later if rising asset or even consumer prices makes the central bank reverse course and jack up interest rates. But even if the central bank keeps rates permanently down, eventually the physical realities will manifest themselves and the economy will suffer a crash.
 Murphy then turns his attention to responding to specific criticisms of Krugman. Krugman asks if Austrian theory is true, why can central banks cause an economic slow-down? Murphy responds in essense, "What do you mean why? That is part of the theory!"
[Krugman] 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.
Murphy writes an exceptionally good paragraph explaining why capital consumption occurs via malinvestment during an inflationary boom.
. . .during the boom period, entrepreneurs (led by false signals) invest in projects that are individually rational and "efficient," but that don't mesh with each other. In other words, it's not so much that a farmer forgets to plant some of the seed corn in order to have a future crop. Rather, it's that a farmer plans on expanding his output, and so he plants much more than he did in the past, but unbeknownst to him, the owners of the silos and railroads (needed to bring the harvest to market) aren't expanding their own operations at the same pace.
This is such a crucial point. Capital is consumed in plans that cannot be carried out, because their simply are not enough capital goods in existence to finish all investment projects. There are not enough capital goods, because there has not been enough voluntary savings to fund their production.

In respond to Krugman's complaint that there is no evidence that an economy's capacity is damaged during booms, Murphy makes the uncomfortable-for-modern-macroeconomists, yet true, point that
. . .there is no simple statistic to which we can point. Austrians are correct to say that "measured investment may not show what's really happening," and correct to say that production is much more complex than depicted in Krugman's models. This isn't "cosmic talk" but a statement of basic facts.
Precisely! The capital structure is, in fact, a complex, multi-stage, structure of heterogeneous capital goods. To deny this is to deny reality.
Murphy goes on, however, to point to statistics such as housing prices, the trade balance, construction employment and home vacancy rates, all of which support Austrian theory. As he notes
Because Krugman was the one who set up these two challenges, it is significant that the Austrian theory passed with flying colors. Furthermore, it is significant that Krugman's own theory cannot explain the actual sectoral shifts in the labor markets. Remember, Krugman wasn't at all embarrassed by the data when he (erroneously) thought the housing bubble had little to do with the unemployment problem.

This is very important, because it was Krugman who notoriously advocated (in 2002) and then defended (with caveats in 2006) the creation of a housing bubble.
 All in all a tremendous performance that should be read in its entirety. If you want a clear, concise, and brief exposition of Austrian business cycle theory, this is a good place to start.

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