This is an expanded version of today’s Mises Daily article with additional analysis and more references to scholarly articles:
More Evidence That Krugman Is Wrong About Hayek and Mises
Paul Krugman has recently been critical of Friedman (and Phelps), the Phillips Curve, and the Natural Unemployment Rate (NUR) theory (“Milton Friedman, Unperson”). Per Krugman in the aftermath of the Great Recession, the accompanying financial crisis, and follow-up Bush-Obama-Fed Great Stagnation, Friedman has vanished from the policy front. Krugman makes this claim despite the fact that there is an on-going vigorous debate on rules versus discretion with at least some attention to Friedman’s plucking model (“Friedman’s ‘Plucking Model’: Comment“ or Austrian Business Cycles and Plucking Models). 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 Keynes-Hayek Debate: Lessons for Contemporary Business Cycle Theorists). 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, a 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.” Ravier, in a new QJAE paper, argues, correctly in my view, that the long-run Phillips is in fact upward sloping. My early work with Fred Glahe on Hayek and Keynes (The Keynes-Hayek Debate: Lessons for Contemporary Business Cycle Theorists and The Hayek-Keynes Debate – Lessons for Current Business Cycle Research) 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 have now more to offer than Keynes (Capital-Based Macroeconomics: Austrians, Keynes, and Keynesians). The Austrian approach with capital structure and money and banking integrated into the analysis is the key to understanding boom-bust cycles. In fact, the most recent boom-bust episodes illustrate the policy errors and damage that can be inflicted on an economy even in a stable money or stable inflation policy environment such as that which produced the Great Moderation (Cochran, Hayek and the 21st Century Boom-Bust and Recession-Recovery, Fisher, Monetary Policy and Capital-Based Macroeconomics: An Empirical Examination for the United States (1963–2012), and Young, Austrian Business Cycle Theory: A Modern Appraisal).
Recent papers by respected main stream economists are beginning to recognize that attention to Hayek and Mises can be useful. Guillermo Calvo of Columbia University, in a recent paper , Puzzling Over the Anatomy of Crises: Liquidity and the Veil of Finance,” 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 – disregarded by mainstream macro theory – that help to rationalize Puzzle 1 without resorting to irrationality.” Calvo defines Puzzle 1:
There is a growing empirical literature purporting to show that financial crises are preceded by credit booms (Mendoza and Terrones (2008), Schularik and Taylor (2012), Agosin and Huaita (2012), Borio (2012)). Adding “This was a central theme in the Austrian School of Economics (see Hayek (2008), Mises (1952)).
Borio, cited by Calvo above, highlights what Austrian’s have long argued is a key flaw in an inflation targeting or a stable money policy regime such as many central banks either adopted or emulated during the 1980-2008 period that contributed to back to back boom-busts of the late 1990s and 2000s (Garrison, “Interest-Rate Targeting during the Great Moderation: a Reappraisal”). According to Borio:
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: they raise growth potential and hence the scope for credit and asset price booms while at the same time putting downward pressure on inflation, thereby constraining the room for monetary policy tightening.
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 (“Should Monetary Policy Lean or Clean?”in Boom and Bust Banking The Causes and Cures of the Great Recession) as does Calvo, “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.”
There is another area where an Austrian approach provides a better understanding of the impact of monetary policy on the economy in an area where NUR based models are weak. This difference is highly relevant in today’s economic climate. In the Friedman-Phelps approach, expansionary policy had no long run impact on the unemployment rate, but the cycle aspects of the model were operative only if the policy shock begun when the economy was already at the natural rate (Time and Money, chapter 10). On the effect of an easy policy on an economy already in a recession, the literature is either mostly silent or leaves open the possibility that policy could speed recovery; albeit with a cost of slightly higher stable inflation. Thus 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 (Not Enough Inflation?). ABCT, as recognized by Borio and Calvo, provides analysis on why such a policy may be ineffective and even if temporarily effective in the short run, harmful if not destructive, in the long run (Ravier, Monetary Theory and the Phillips Curve with a Positive Slope and Rethinking Capital-Based Macroeconomics and Cochran, Capital in Disequilibrium: Understanding the “Great Recession” and the Potential for Recovery). 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.”
Hayek’s explanation, in particular, can be summarized in one word: Complexity; implying the inability of policymakers to know the inner workings of a mechanism that went awry by excessive credit in such a way that when the boom reaches its peak, the policymaker cannot possibly know where to operate due to the complexity of the situation, even leaving aside political considerations. Moreover, when account is taken of the fact that the policymaker has only a limited set of blunt instruments to operate, it is not hard to conclude that countercyclical policy may be largely ineffective – in the lucky case in which it is not outright counterproductive.
Borio argues along similar lines (references deleted):
More generally, there is a risk that failing to recognise that the financial cycle has a longer duration than the business cycle could lead policymakers astray. This occurs in the context of what might be called the “unfinished recession” phenomenon. Specifically, policy responses that fail to take medium-term financial cycles into account can contain recessions in the short run but at the cost of larger recessions down the road [emphasis added]. In these cases, policymakers may focus too much on equity prices and standard business cycle measures and lose sight of the continued build-up of the financial cycle. The bust that then follows an unchecked financial boom brings about much larger economic dislocations. In other words, dealing with the immediate recession while not addressing the build-up of financial imbalances simply postpones the day of reckoning.
Acknowledgement of and use by prominent non-Austrian economists of the contributions of Mises and Hayek is encouraging. It has been a long time coming. Cochran and Glahe argued as long ago as 1994 that (references deleted):
Open-minded debate concerning issues presented in the Keynes-Hayek paradigm clash could further understanding if only by making us more aware of how little we really know about certain key aspects determining the course of economic events. Crucial questions about the role of money and time cannot be effectively addressed in simple quantity equation-type models or in general equilibrium growth models with a single homogeneous capital good. The crucial roles of money and time cannot be effectively addressed in models without also addressing issues in capital theory and the time structure of production. Discussion about policies affecting full employment and economic stability will be inadequate if related problems in capital theory are at the same time ignored. The allocational efficiency and stability efficiency properties of a market economy depend on decisions to use current resources to produce additional resources. This critical issue is at the heart of both Keynes’s and Hayek’s analyses. A redirection of the policy effectiveness debate along these lines could greatly enhance our understanding of a monetary production economy.
It is too bad it took back-to back destructive boom-bust cycles for the profession at large to begin to again examine Austrian insights. This new literature does illustrate how foolish Krugman is when he argues Austrians have nothing to bring to the table. Now if more attention was devoted to a careful reading of contributions such as Salerno’s A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis, Garrison’s “Leveraging Alchemy: The Federal Reserve and Modern Finance, “Natural Rates of Interest and Sustainable Growth,” and “Interest-Rate Targeting during the Great Moderation: a Reappraisal,” or Ravier’s and Lewin’s The Subprime Crisis the professions understanding of the causes of the boom-bust generated crisis and the need for monetary reform would be greatly enhanced.