Robert Murphy's Retort To Paul Krugman On Austrian Business-Cycle Theory

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A must read reply to that discredited shaman of voodoonomics, Paul Krugman, by one of the more notable proponents of Austrian theory, Mises Institute's Robert Murphy.

My Reply to Krugman on Austrian Business-Cycle Theory, from Robert Murphy of the Ludwig von Mises Institute

As many readers already know, last week Paul Krugman linked to one of my Mises Daily articles explaining the importance of capital theory
in any discussion of the business cycle. Although Krugman graciously
described my fable about sushi-eating islanders as "the best exposition
I've seen yet of the Austrian view that's sweeping the GOP," naturally
he derided the approach as a "great leap backward" and a repudiation of
75 years of economic progress since the work of John Maynard Keynes. To
bolster his rejection, Krugman listed several problems he saw with the
Austrian understanding.

In the present article I'll first summarize the Austrian (in the
tradition of Ludwig von Mises) positions on capital theory, interest,
and the business cycle. With that as a backdrop, I will then answer
Krugman's specific objections.

The Austrians on Capital

In contrast to mainstream macro models, which either do not possess
capital at all or at best denote it as a homogenous stock of size "K,"
Austrian theory explicitly treats the capital structure of the economy
as a complex assortment of different tools, equipment, machinery,
inventories, and other goods in process. Much of the Austrian
perspective is dependent on this rich view of the economy's capital
structure, and mainstream economists miss out on many of the Austrian
insights when they make the "convenient" assumption that the economy has
one good. (Krugman will be glad to know that yes, I can spell all this
out in a formal model — and one that referee Paul Samuelson grudgingly
signed off on.Download PDF)

Krugman and other Keynesians stress the primacy of demand:
they keep pointing out that the owner of an electronics store, say,
won't have the incentive to hire more workers, and buy more inventory,
if he doesn't expect consumers will show up with money to spend on new
TVs or laptops.

But Austrians point out that demand per se is hardly the whole story:
Regardless of how many green pieces of paper the customers have, or how
much credit the store can get from the bank, it will be physically impossible for the electronics store to fill the shelves with new TVs and laptops unless the manufacturers of those items have already produced
them. And in turn, the manufacturers can't magically create TVs and
laptops merely because the demand for their products picks up; they rely
on other sectors in the economy having done the prior
preparation as well, such as mining the necessary metals, assembling the
proper amount of tractor trailers needed to ship the goods from the
factory, and so on.

These observations may strike some as trivial, not worthy of the
consideration of serious economists. But that's only because normally, a
market economy "spontaneously" solves this tremendous coordination
problem through prices and the corresponding signals of profit and loss.
If someone had to centrally plan an entire economy from scratch, there
would be all sorts of bottlenecks and waste — as the actual experience
of socialism has shown.

Without the guidance of market prices, we wouldn't observe a smoothly
functioning economy, where natural resources move down the chain of
production — from mining to processing to manufacturing to wholesale to
retail — as neatly depicted in macro textbooks. Instead, we would see a
chaotic muddle where the various interlocking processes didn't dovetail.
There would be too many hammers and not enough nails, too much
perishable food and not enough refrigerated railroad cars to deliver it,
and so on.

The Austrians on Interest

When it comes to explaining the coordinating function of market
prices, Austrians assign a very important role to interest rates, for
they steer the deployment of resources over time. Loosely
speaking, a high interest rate means that consumers are relatively
impatient, and penalize entrepreneurs heavily when they tie up resources
in long-term projects. In contrast, a low interest rate is the market's
green light to entrepreneurs that consumers are willing to wait longer
for the finished product, and so it is acceptable to tie up resources in
projects that will produce valuable goods and services at a much later

In the Austrian conception, it is the interest rate that allows the
financial decisions of households to interact with the physical capital
structure, so that producers transform resources in the ways that best
satisfy consumer preferences. Consider a simple example that I use for
undergraduates: Suppose the economy is in an initial equilibrium where
households save 5 percent of their income. Then the households decide
that they want to have more for their retirement years, because they
don't want their standard of living to plummet once they stop working.
So all the households in the community begin saving 10 percent of their

In the Austrian view, the interest rate is the primary mechanism
through which the economy adjusts to the change in preferences. (It's
not that people switched from buying hot dogs to hamburgers; instead
they switched from buying "present consumption" to buying "future
consumption.") The increased household saving pushes down interest
rates, and at the lower rates businesses can start long-term projects.
From the individual entrepreneur's point of view, the interest rate
affects the profitability of longer projects more than shorter
ones (as a simple "present-discounted-value" calculation shows). So a
lower interest rate doesn't merely stimulate "investment" but actually
gives a greater inducement to investment in durable, long-term goods, as
opposed to investment in nondurable, short-term goods.

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.

The Austrians on the Business Cycle

Now that I've given a summary of the Austrian view of capital and
interest, we get the reward: their explanation of the business cycle.
When interest rates are pushed down below their market levels (by
expansionary central-bank policy, for example), this sets in motion the
same processes that would occur if there were an actual increase in
savings. In other words, at the lower interest rate, entrepreneurs find
it profitable to begin long-term projects; the capital-goods sectors of
the economy begin hiring workers and increasing output.

However, this expansion of the capital-goods sectors isn't
counterbalanced by a shrinking of the consumption-goods sectors, the way
it would be if households actually started saving more. Instead, the
households try to consume more too, because of the lower interest rates.

An unsustainable boom sets in, a temporary period of illusory
prosperity. Because every sector is expanding, there is a general
feeling of euphoria; it seems every business is having a "great year,"
and the unemployment rate falls below its "natural" level.

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.

During the bust phase, entrepreneurs will reevaluate the situation.
If the government and central bank don't interfere, prices will give
accurate signals about which enterprises should be salvaged and which
should be scrapped. Those workers who are in unsustainable lines will be
laid off. It will take time for them to search through the developing
opportunities and find a niche that is suitable for their skills and is
sustainable in the new economy.

During this period of reevaluation and search, the measured
unemployment rate will be unusually high. It's not that workers are
"idle," or that their productivity has suddenly dropped to zero;
rather, it's that they need to be reallocated, and that takes time in a
complex, modern economy. This delay can be due to simple search, where
the workers have to look around to find the best spot that is already
"out there," or it can be due to the fact that they have to wait on
other workers to "get things ready" before the unemployed workers can
resume. (This is what happened in my sushi story.)

I'll stop the summary at this point in order to address Krugman's
objections. The interested reader can see more technical (yet still
accessible) expositions in this collection of essays,
while those interested in a graphical exposition (using mainstream
concepts such as the PPF) should check out Roger Garrison's fantastic PowerPoint presentations.

Answering Krugman

My reason for the lengthy summary is that 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 and nets. This neglect
wouldn't show up overnight, but eventually the village economy would
crash. To repeat, I chose this illustration to make basic points about
the capital structure and how short-term consumption binges can be
physically possible, but must still be "paid for" in the long run.

Unfortunately, my fable and the lessons I drew from it gave the impression (see Tyler Cowen's critique)
that the Austrians think the "capital consumption" during the
unsustainable boom period must show up in things like reduced spending
on building maintenance, or perhaps in the owner of a fleet of trucks
neglecting to have the tires rotated.

In reality, it's more accurate to say that 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.

In summary, it's not that the Austrians think an inspection of an
individual enterprise will reveal a technological deficiency. Rather,
it's that all of the entrepreneurs are "getting ahead of themselves,"
trying to develop too quickly. There aren't enough real savings to allow
all of the new processes to be completed. To capture this aspect of the
Austrian theory, Mises's analogy of a homebuilder (who draws up blueprints thinking he has more bricks than he really does) is still the best.

Krugman Wants to Know: Where's the Evidence?

This leads into Krugman's central complaint:

Oh, and what evidence is there that the economy's capacity is
damaged during booms? Investment rises, not falls, during booms; yes, I
know that Austrians take refuge in cosmic talk about the complexity of
production and how measured investment may not show what's really
happening, etc., but where's the positive evidence of what they're

I can sympathize with Krugman, but 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.

But to answer his question, Austrians certainly can point to
positive evidence of their view. For example, Austrians argue that
during the housing boom years, Americans didn't save enough out of their
wage and salary income, because they were misled into thinking they
were much wealthier than they really were. Then when reality set in the
illusion was shattered, and valuations of capital assets fell sharply.
Realizing they had made terrible decisions during the boom, Americans
sharply increased their savings. The data match this story pretty well:

Figure 1

The above chart shows that the savings rate (blue) plummeted during
the peak years of the housing bubble, as the S&P 500 (red) zoomed
upward. Then in late 2007 the stock market began crashing, while the
savings rate increased very sharply. The stock market turned around in
early 2009, of course, but from the Austrian perspective, this is
because the Fed's massive interventions — capped off by the first round
of "quantitative easing" (which was announced at this time) — started
artificially blowing up asset prices again.

We can also get hard empirical support for the Austrian claim that
the housing boom drew an unsustainable amount of real resources
(including labor) into that sector, which eventually collapsed and
caused a spike in unemployment. The following chart compares total
construction employment (blue line) with the home vacancy rate
(red line), which is a good indication of a speculative bubble: people
were buying homes not to live in, or even to rent out, but to "flip"
when the price went up. Notice the connection between the speculative
housing bubble and the workers sucked into — and then expelled from —

Figure 2

When it comes to applying the generic Austrian theory to the recent
boom-bust cycle, we have to think globally. During the boom, much of the
rising stream of consumption goods enjoyed by Americans was physically
produced in China and other foreign countries. To put it in terms
Krugman will appreciate, we could say that the boom period's surge in
imports (which "subtract" from GDP)
was consistent with a "healthy" string of GDP increases, not because of
counterbalancing exports, but rather because Americans and their
government kept spending more and more each year (thus boosting C, I, and G), more than offsetting the growing trade imbalance.

There is nothing wrong with a trade deficit (or more accurately, a current account deficit) per se; elsewhere I explained
how a very healthy and sustainably growing economy could have an
indefinite stream of such deficits, as the rest of the world rushed to
invest in a country blessed with attractive policies.

But when it comes to the actual housing boom under George W. Bush,
Americans' accumulation of SUVs, plasma-screen TVs, and gaming consoles
was clearly unsustainable. This is not because — as in my sushi story —
Americans were forgetting to do standard maintenance. Rather, it is
because Americans couldn't possibly have kept "total output" — which is
very imperfectly captured in our official GDP figures — at the dizzying
height at the end of the boom period, because it required foreign
producers to continue sending us goodies in exchange for ownership
claims on a growing collection of McMansions in which nobody could
afford to live.

To make sure that this intuitive story fits the facts, we can chart
an index of home prices (blue) against the current account balance
(red). The figure below illustrates quite nicely that as the housing
bubble inflated, the current account sank more deeply negative. Then the
housing bubble and the trade deficit both began collapsing at roughly
the same period, as American consumers (and foreign investors) came to
their senses.

Figure 3

Of course, Krugman's models and interpretation can incorporate the
above evidence too. So he could understandably claim that he has no
reason to credit the Austrian view over his own.

But I can point to at least two episodes where the
"sectoral-readjustment" story of the Austrians clearly has more
explanatory power than Krugman's "insufficient demand" story.
Specifically, in late 2008 Krugman argued
that the housing bust had little to do with the recession, because the
latest BLS figures showed that unemployment at the state level bore
little relationship to the declines in home prices across the states.

However, I pointed out that looking at year-over-year changes in unemployment at the end of 2008 was hardly the right test. If we looked at changes from the moment the housing bubble burst,
then five of the six states with the biggest housing declines were also
in the list of the six states with the biggest increases in

On another occasion (last summer), Krugman once again
thought he had dealt the readjustment story a crushing blow when he
pointed out that manufacturing had lost more jobs than construction. I pointed out that this too wasn't a valid test, because manufacturing had more workers to begin with. When we looked at percentage
declines, then construction did indeed crash more heavily than
manufacturing. Furthermore — and just as Austrian theory predicts — the
employment decline in durable-goods manufacturing was worse than
in nondurable-goods manufacturing, while the decline in the retail
sector was lighter than in the other three.

These are very important episodes. When Krugman thought the numbers
were on his side, he was happy to cast aspersions on the
sectoral-readjustment story; he thought his own model was perfectly able
to explain the situation if the crash in housing really didn't have much to do with the upheaval in the labor markets. And, as Krugman himself argued, had he been using valid tests, then the outcomes would indeed have been challenging to the Austrian story.

So now that we see the changes in employment really do match
up with the Austrian explanation, we should be much more confident that
it is capturing at least an important part of the story. To repeat, I
didn't set out to find data that matched the Misesian exposition and
then finally settled on some charts that did the trick. Rather, Krugman thought he had found a falsification of the theory, but it turned out he had conducted a poor experiment.

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

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.

I am not engaging in a character attack or "gotcha" by pointing this
out: it is very significant that Krugman's model prescribed a housing
bubble as a solution to the dotcom crash, even though — as we've seen —
Krugman's model is obviously inferior to the Austrian explanation when
it comes to assessing the fallout from the housing bubble.


I do not claim that the Austrian theory of the business cycle captures every pertinent feature of modern recessions. What I do
claim is that a theory — including any of Paul Krugman's Keynesian
models — that neglects the distortion of the capital structure during
boom periods cannot possibly hope to accurately prescribe policy
solutions after a crash.