Krugman on the Hangover Theory

14 October 2008 at 9:18 am Leave a comment

| Peter Klein |

More than one commentator has compared the economy in the current crisis to an alcoholic in the early stages of withdrawal. Going back on the bottle makes everything feel good again, but only puts off the inevitable. Ultimately, there can be no recovery without a painful rehab.

Keeping in mind Bob Higgs’s strictures about the misuse of metaphors, the illustration does serve a useful purpose. It helps demonstrate, as I’ve argued before, that the problem is not that overall lending is too low, but that the wrong loans were made by the wrong lenders to the wrong people (and, by extension, the wrong mortgage-backed securities boughy by the wrong investors, and so on). They key to recovery is not injecting “liquidity” into the system, but reallocating financial resources to the right borrowers and investors. In short, the worst thing we can be doing now is propping up the bad investments made during the boom, bailing out the unwise borrowers, lenders, and investors, putting off the liquidiation and reallocation that are ultimately necessary for recovery. All we have done over the last few weeks is give the alchoholic a few more drinks.

Paul Krugman’s Nobel citation, while focusing on his contributions to trade theory, mentions briefly his more recent work on financial crises. On this topic Krugman is more-or-less an unreconstructed, liquidity-trap Keynesian (Shawn Ritenour calls him a “paleo-Keynesian”). Krugman once wrote a popular piece about the Austrian approach to the business cycle, which he called the “hangover theory” of recessions. You can get a sense of how seriously Krugman takes the argument by his dismissive tone, writing for example about “those supposedly deep Austrian theorists” who failed to realize that total spending equals total consumption plus total investment. Clearly, he has read the Austrians as carefully as he has read Bertil Ohlin. Still, his essay gave Roger Garrison, John Cochran, and David Gordon the opportunity to respond with essays explaining the Austrian theory. (Krugman, characteristically, is unaware that the Austrian account of cycles is built on a particular theory of capital. If bad investments were made during the boom, he says, “Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?” Um, Paul, it’s called asset specificity.)

Update: Here’s another response to Krugman (and Tyler Cowen) by Bob Murphy.

Entry filed under: - Klein -, Austrian Economics.

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