Has Paul Krugman Become an Austrian Economist? Not Quite….

By: LewRockwell

William L. Anderson writes: Paul Krugman has looked at Austrian Theory of the Business Cycle and found it wanting. First, he mistakenly calls it a "hangover theory" when, in fact, it is a theory of easy credit leading to malinvestments. Second, he really does not understand that government cannot sustain a boom once the financial wave has crested. Third, he has no understanding of the heterogeneity of assets, assuming that capital and other assets are homogeneous for the purposes of economic policy.

However, in his recent column, he did make a (sort of) reference to malinvestments. He does not call them as such, but does make a reference to assets that could not be sustained in the boom:

Financial firms, we now know, directed vast quantities of capital into the construction of unsellable houses and empty shopping malls. They increased risk rather than reducing it, and concentrated risk rather than spreading it. In effect, the industry was selling dangerous patent medicine to gullible consumers.

Granted, this is pretty stern stuff from someone who called for then-President Bush and the Fed to start a housing bubble (and then say later he only was kidding). However, what he said has some truth to it, as it was not just the "banksters" that were selling the snake oil, but the "elite" economists as well. (One remembers how Arthur Laffer excoriated Peter Schiff for sounding the alarm in 2006.)

The other thing to keep in mind is that Krugman actually seems to be differentiating between assets that are sustainable and those that cannot be sustained. Can he be saying that assets and capital really are heterogeneous as say the Austrians versus the belief of Keynesians that assets are homogeneous, as the Keynesians claim in their policy prescriptions? (Indeed, that seems to be a fundamental tenet of Krugman’s claim that "depression economics" changes the rules.)

Unfortunately, he never takes that statement to its logical conclusions. Instead, he uses it as a lead-in to his usual point: banks must be both cartelized and regulated:

The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. If you’re a banker, and you generate big short-term profits, you get lavishly rewarded – and you don’t have to give the money back if and when those profits turn out to have been a mirage. You have every reason, then, to steer investors into taking risks they don’t understand.

And the events of the past year have skewed those incentives even more, by putting taxpayers as well as investors on the hook if things go wrong.

I won’t try to parse the competing claims about how much direct benefit Goldman received from recent financial bailouts, especially the government’s assumption of A.I.G.’s liabilities. What’s clear is that Wall Street in general, Goldman very much included, benefited hugely from the government’s provision of a financial backstop – an assurance that it will rescue major financial players whenever things go wrong.

All of this is (gasp!) true. Indeed, the famed "Greenspan Put" always was in the back of the minds of the banksters when they were playing the high-roller game. But, alas, Krugman does not seem to understand the logical implications of his statement (again):

You can argue that such rescues are necessary if we’re to avoid a replay of the Great Depression. In fact, I agree. But the result is that the financial system’s liabilities are now backed by an implicit government guarantee.

Now the last time there was a comparable expansion of the financial safety net, the creation of federal deposit insurance in the 1930s, it was accompanied by much tighter regulation, to ensure that banks didn’t abuse their privileges. This time, new regulations are still in the drawing-board stage – and the finance lobby is already fighting against even the most basic protections for consumers.

The problem, of course, is that government regulation creates real-live cartels that, while regulated, still are not going to serve consumers in a way that free-market firms would do. As I have stated elsewhere, the "Land of Oz" banking system that Krugman so touts actually fell apart in the late 1970s because of inflation and its inability to deal with the new technologies that were waiting to have investments made. Thus, it fell to people like Michael Milken and others who operated outside the financial cartel to set the stage for the high-tech revolution.

To Krugman the Keynesian, however, all of this is gibberish. Economies grow, in his view, because people increase spending, and if people hold back and investors don’t invest, then government steps in and fills the void. It is all so easy – and all so wrong.

There is another way, called profit and loss. In the real world, profits and losses serve as the bellwethers of regulation. Furthermore, if financial firms know that they are not operating with the government covering their losses, then the investment decisions that they make will differ greatly from those made when the "put" is at their backs.

Unfortunately, Krugman and most other "elite" economists don’t come close to understanding this simple point. Instead, they really seem to believe that banking and finance are different, and must be both cartelized and protected.

So, while Krugman seems to understand, if only for a fleeting moment, that assets might be heterogeneous and that government guarantees create huge moral hazards, nonetheless in the end his Keynesianism bleeds through. Like the Bourbons of France, he learns nothing and he forgets nothing.

The former boxer Terry in "On the Waterfront" lamented that he "coulda been a contender." With some sound economic background, Krugman could have been an Austrian. Unfortunately, he has decided to swallow the same snake oil that he claims that the banksters were selling, and it turned him into a Keynesian. He may be famous, he may be a Nobel Prize winner, but he still is wrong.

William L. Anderson, Ph.D. [send him mail], teaches economics at Frostburg State University in Maryland, and is an adjunct scholar of the Ludwig von Mises Institute. He also is a consultant with American Economic Services. Visit his blog.

http://www.lewrockwell.com

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