Mises: Mainstream Economists Prove Krugman Wrong About Austrian Economics

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This post, written by John P. Chochran, originally appeared on the Ludwig von Mises Institute website on September 11.

Paul Krugman has recently been critical of Friedman (and Phelps), the Phillips curve, and the Natural Unemployment Rate (NUR) theory in the process of arguing that due to the recent Great Recession, the accompanying financial crisis, and Bush-Obama-Fed Great Stagnation, Friedman has vanished from the policy front. Krugman makes this claim despite the fact there is an on-going vigorous debate on rules versus discretion with at least some attention to Friedman’s plucking model. While maligning Friedman’s contributions, Krugman manages a slap at Austrians and claims a renewed practical relevance for Keynes:

What I think is really interesting is the way Friedman has virtually vanished from policy discourse. Keynes is very much back, even if that fact drives some economists crazy; Hayek is back in some sense, even if one has the suspicion that many self-proclaimed Austrians bring little to the table but the notion that fiat money is the root of all evil — a deeply anti-Friedmanian position. But Friedman is pretty much absent.

The Friedman-Phelps hypothesis was the heart of the policy effectiveness debate of the 1970s and early 80s. The empirical evidence developed during the debate over the policy implications of the NUR model, at least temporally, discredited active Keynesian discretionary policy as an effective tool to reduce unemployment in the long run. One result of the debate: monetary policy appeared to improve, especially compared to the Fed’s dismal record in the late 1920s and 1930s and the mid 1960s to the late 1970s. Central banks, à la Friedman, focused on rules-based policy and inflation targeting resulting in what many, following John B. Taylor, call the Great Moderation of the early 1980s to the early 2000s.

Krugman does recognize the “stagflation (of the 1970s) led to a major rethinking of macroeconomics, all across the board; even staunch Keynesians conceded that Friedman/Phelps had been right (indeed, they may have conceded too much [emphasis added]), and the vertical long-run Phillips curve became part of every textbook.”

My early work on Hayek and Keynes (see here and here) argued that this development was important, but misleading. The then current business cycle research and its newer variants could benefit from re-examining the issues at the heart of the Hayek-Keynes debate.

Money, banking, finance, and capital structure were, and still are, for the most part ignored in much of the new (post-Friedman-Phelps) macroeconomics including the new–Keynesian approaches. In this regard, Hayek (and Mises) had then, and has now, more to offer than Keynes.

Recent papers by respected mainstream economists are beginning to recognize that attention to Hayek and Mises can be useful. Guillermo Calvo of Columbia University, in a recent paper [PDF], has even gone so far as to argue, “the Austrian school of the trade cycle was on the right track” and that the Austrian School offered valuable insights and noting that:

There is a growing empirical literature purporting to show that financial crises are preceded by credit booms including Mendoza and Terrones (2008), Schularik and Taylor (2012), Agosin and Huaita (2012), and Borio (2012).

Calvo adds “[t]his was a central theme in the Austrian School of Economics.”

Claudio Borio highlights what Austrians have long argued is a key flaw in inflation-targeting or stable-money policy regimes such as many central banks either adopted or emulated during the 1980-2008 period. This flaw contributed to back-to-back boom-busts of the late 1990s and 2000s:

A monetary policy regime narrowly focused on controlling near-term inflation removes the need to tighten policy when financial booms take hold against the backdrop of low and stable inflation. And major positive supply-side developments, such as those associated with the globalisation of the real side of the economy, provide plenty of fuel for financial booms.

Borio thus recognizes that a time to mitigate a bust is (contra-Keynes) during the boom:

In the case of monetary policy, it is necessary to adopt strategies that allow central banks to tighten so as to lean against the build-up of financial imbalances even if near-term inflation remains subdued.

William R. White, another economist who has worked at the Bank of International Settlements (BIS) and has been influenced by Hayek, has come to similar conclusions as does Calvo, who argues “Hayek’s theory is very subtle and shows that even a central bank that follows a stable monetary policy may not be able to prevent business cycles and, occasionally, major boom-bust episodes.”

In the current environment, many, including Krugman, have argued for a higher inflation target or a higher nominal GDP target to jump start the current sluggish recovery.

Austrian business cycle theory on the other hand, as recognized by Borio and Calvo, provides analysis on why such a policy may be ineffective and if temporarily effective in the short run, harmful if not destructive, in the long run. (See here and here for more.)

An easy money and credit policy impedes necessary re-structuring of the economy and new credit creation begins a new round of misdirection of production leading to an “unfinished recession.” Calvo expounds:

Whatever one thinks of the power of the Hayek/Mises mix as a positive theory of the business cycle, an insight from the theory is that once credit over-expansion hits the real sector, rolling back credit is unlikely to be able to put “Humpty-Dumpty together again.”

It is too bad it took back-to back harmful boom-bust cycles for the profession at large to begin to again examine Austrian insights, but it does illustrate how foolish Krugman is when he argues Austrians have nothing to bring to the table.

John P. Cochran is emeritus dean of the Business School and emeritus professor of economics at Metropolitan State University of Denver and coauthor with Fred R. Glahe of “The Hayek-Keynes Debate: Lessons for Current Business Cycle Research”. He is also a senior scholar for the Mises Institute and serves on the editorial board of the Quarterly Journal of Austrian Economics.

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  • freedomringsforall

    Amen
    like – DUH

  • shrgngatlas

    If you want good, positive economic information, the Mises Institute is the place to go. I’ve had them bookmarked for over 10 years. Did you know they were warning about the housing bubble as early as 2004? They had it all analyzed, and predicted virtually exactly what happened over 4 years in advance. But after the burst, the mainstream STILL ignored them and blamed it on LACK of regulation instead of government, Fannie, and Freddie interference in the mortgage market as had been warned by the Mises Institute economists.

    • Cowboydroid

      Austrian theory is ignored by those in power making economic policy because it necessarily requires them to give up power and quit manipulating the market to satisfy their own goals and special interests.

      Keynesian theory has succeeded because it appeals to economic special interests, and gives politicians the “intellectual” support they need in expanding their own power and reducing civil and economic liberties.

      Monetarism, the theory that the money supply can be manipulated in order to positively influence the economy, is also quite flawed in its premise, and is the real source of economic destruction. Monetarism has been around quite a bit longer than Keynesianism, in the form of central banking. Central banks tried and failed to establish themselves in America in the 19th century, being ruled unConstitutional multiple times, and the Founders providing warning after warning against them. They finally succeeded in 1913 under Wilson, and that was the beginning of our real economic woes, and the beginning of wealth redistribution to the top 1%, which is at a historical high today.

      • shrgngatlas

        You’re absolutely right here, and say almost exactly what I have written in other posts about Austrian vs. Keynesian economics. However, it is my opinion that the skewing of incomes and squeezing of the middle class is more due to the high degree of “crony capitalism” whereby lobbyists push for legislation that favors regulations of their own industries that have a negligible cost to the large established companies (who also happen to be large campaign contributors) while causing prohibitive costs to smaller competitors and start ups who might outshine the established companies if they weren’t buried with these regulations. This allows the established companies to be virtually guaranteed market share and good profits no matter how lazy and lacking in inventiveness they become, and which continues to funnel wealth to that top 1% whether they deserve it or not. And yes, 1913, one hundred years ago, with the inauguration of Wilson, the passage of the Federal Reserve Act and the ratification (? there are questions about this in some states) of the flawed and largely misapplied 16th amendment was a very dark year in American History.

        • Cowboydroid

          The causes of wealth concentration are not exclusive to each other. Government, central banks, and corporations work together to squeeze wealth and capital from the general population. Governments create corporations and central banks through legalese, and central banks and corporations lobby governments for favorable legislation to further their own special interests.

          Without central banks, corporations might still exist, but they would at least be forced to take natural risks with capital based on natural interest rates, lessening the effects of the boom/bust cycle. Without incorporation, central banks might still exist, but at least capital wouldn’t gravitate towards large, unaccountable corporations, endangering the broader economy with excessive risk-taking. When the two exist together, it’s a recipe for capital concentration, the destruction of competition, and the impoverishment of the People. When they are both eliminated, there is a veritable economic paradise with the elimination of the boom/bust cycle and broad control of capital by equal players in the market.

          Agree about the year of 1913. The beginning of the end, as far as we’re all concerned. Hopefully that end approaches swiftly, and we can enter a new age of enlightenment.

          • TheOriginalDaveH

            Excellent comments — Both of you.
            Where are you guys when I need you on the other boards?

          • Cowboydroid

            I try to get around, although it usually just depends on what pops up in my news feed.