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Why 95% of Traders Fail

The Price of Employment is Wrong – and So is Krugman

Economics / Employment Apr 21, 2013 - 11:17 AM GMT

By: William_Anderson

Economics

Every once in a while, Paul Krugman gives an object lesson in Keynesian economics and his M.O. generally is as follows:

  • create a caricature of other points of view which is built on faulty assumptions and outright misrepresentations of the real position
  • discredit that phony caricature
  • claim victory

In a recent blog post, Krugman looks at unemployment and its causes, assigns the Austrians to something they don’t believe, and then claims that the Keynesian way is morally and economically superior even though his description of the Keynesian “solution” is to do exactly what he has condemned elsewhere: cutting real wages. To put it another way, it is more of the same. He writes:

So, start with our big problem, which is mass unemployment. Basic supply and demand analysis says that things like that aren’t supposed to happen: prices are supposed to rise or fall to clear markets. So what’s with this apparent massive and persistent excess supply of labor?

In general, market disequilibrium is a sign of prices out of whack; and most people commenting on our mess accept the notion that one or more prices are for some reason not adjusting. The big divide comes over the question of which price is wrong.

Then he jumps on the Austrians:

As I see it, the whole structural/classical/Austrian/supply-side/whatever side of this debate basically believes that the problem lies in the labor market. (I know, the Austrians will deny it — but it doesn’t matter what you say about their position, any comprehensible statement leads to angry claims that you don’t understand their depths.) For some reason, they would argue, wages are too high given the demand for labor. Some of them accept the notion that it’s because of downward nominal wage rigidity; more, I think, believe that workers are being encouraged to hold out for unsustainable wages by moocher-friendly programs like food stamps, unemployment benefits, disability insurance, and whatever.

Actually, this is not the Austrian position at all. Austrians hold that an inflationary boom ultimately runs its course and when the boom collapses, then certain segments of the economy no longer can operate as they did, and one of the effects is for those sectors to shed employees (and in many cases go out of business altogether). In one sense it is true that the sectors have lost “demand” for their goods, but the original demand was based upon an unsustainable injection of credit.

Take the infamous housing boom, for example. The government through the Federal Reserve System, banks, and other agencies directed huge sums of money into the housing sector. In the earlier days of that boom, people could borrow well above their actual equity, pay off their old mortgage, use the new money not only to essentially repurchase or refinance their house but have lots of money left over for which they purchased consumer goods.

The great thing was that the new house payments either were lower (because of lower interest rates) than they had been before, and homeowners could have all sorts of new goods that essentially were “free” to them, or did not increase their monthly payment obligations. It is not hard to see how Americans soon became addicted to that process. (One person whose principal payments had more than doubled told me, “Hey, it’s the American Way.”)

When the refinance boom spread to the game of housing and “house flipping,” Americans became addicted to that way of boosting their wealth, too. Now, sheer logic would tell you that this boom/bubble could not be continued for any length of time — even Krugman and the Austrians agreed on that — and when the end came, the economy was bound to shrink as the malinvestments that had piled up no longer could be financially sustained.

Where Krugman and the Austrians really part company is in how to handle the secondary effects, including unemployment problems that arise as the economy readjusts following the crash. When Austrians note that wages elsewhere are likely to have to fall, they are making that point because a lot of asset prices fall during the immediate and secondary contractions. Austrians believe that the markets should adjust because the quicker the adjustment, the sooner a recovery will begin. Krugman, on the other hand, declares:

What my side of the debate would call for, instead, is a reduction in the real interest rate, if possible, by raising expected inflation; and failing that, more government spending to increase demand and put idle resources to work. (emphasis mine)

Now, Krugman, who also has been agitating for higher minimum wages — that is, bring about real wage increases for the least-skilled workers — also seems to be following the line of the “trick” that Keynes himself recommended: use inflation to cut real wages. I’m using a paraphrase because my copy of the General Theory is in my office at Frostburg, but I believe this is a fair assessment of his position:

Keynes expressed, in numerous passages in The General Theory, the view that wages were “sticky” in terms of money. He noted, for example, that workers and unions tended to fight tooth-and-nail against any attempts by employers to reduce money wages (the actual sum of money workers receive, as opposed to the real purchasing power of these wages, taking account of changes in the cost of living), even by a little bit, in a way they did not fight for increases in wages every time there was a small rise in the cost of living eroding their “real wages.”

The idea was to “cut” real wages via inflation since workers, according to Keynes, were only interested in their “money wages.” Keynes did not argue that such a move would bring back full employment, but he did believe that workers would be less likely to notice that their real purchasing power had eroded.

Now, I believe that the current administration does hold to that viewpoint. Many of us in the workplace have not seen our incomes rise in many years, but the price of nearly everything we purchase has gone up, with some items seeing considerable price increases, including fuel and food. This is no accident; the Obama years have been hard ones for a lot of people, and for blacks, the situation is dire. (I suspect that had a white Republican been in the White House since 2009 and blacks had fared under him as they have fared under Obama, the Republican would be accused of being a racist who was deliberately targeting blacks for unemployment. Obama, on the other hand, gets a free ride.)

The cut-wages-through-inflation strategy is part of Krugman’s heads-I-win-tails-you-lose way of arguing. First he accuses Austrians of believing that all that is needed to restore the economy to full employment is for everyone to get a wage cut, and when Austrians protest such nonsense, he accuses them of trying to be mystics or something similar.

Krugman then attempts to employ a “cure” that cuts real wages as part of restoring full employment all the while claiming it is the Austrians that want others to go hungry. (Paul Krugman always is on the side of humanitarianism, and he is anxious for others to be forced to fund his humanitarian instincts.)

What do Austrians believe about allowing wages and other asset prices to fall? They believe that allowing all prices to return to market levels will hasten the correction and lead more quickly to a situation in which entrepreneurs are able to move assets from lower-valued to higher-valued uses, and strengthening the economy. Out-of-kilter asset prices are only one problem, but they do keep the necessary adjustments from occurring. These prices are the effect of a boom, and they have to settle back to realistic levels following the end of the unsustainable expansion. Rothbard writes:

Since factors must shift from the higher to the lower orders of production, there is inevitable “frictional” unemployment in a depression, but it need not be greater than unemployment attending any other large shift in production. In practice, unemployment will be aggravated by the numerous bankruptcies, and the large errors revealed, but it still need only be temporary. The speedier the adjustment, the more fleeting will the unemployment be. Unemployment will progress beyond the “frictional” stage and become really severe and lasting only if wage rates are kept artificially high and are prevented from falling. If wage rates are kept above the free-market level that clears the demand for and supply of labor, laborers will remain permanently unemployed. The greater the degree of discrepancy, the more severe will the unemployment be.

Rothbard makes it quite clear that out-of-balance wages and other asset prices are the result of the end of the previous boom. They have not caused the downturn; they are the result of the contraction. In other words, Krugman confuses the cause-and-effect process Austrians use by claiming Austrians believe effects actually are the cause of trouble. That is nonsense, but such misrepresentation is a staple of Krugman’s intellectual arsenal.

Krugman, on the other hand, insists that the way to correct the downturn is to create yet another boom. Never mind that the boom that had just collapsed was unsustainable, and that any new credit-fueled boom also will crash down to earth at a future date. However, Krugman apparently wants us to believe that such economic manipulation can go on forever.

But Krugman is not done, declaring:

So how can you tell which side is right? Well, these differing views make differing predictions. If you believe that the problem is excessive wages, you believe that the economy is fundamentally suffering from a supply-side constraint. In that case government borrowing is competing with the private sector for a limited quantity of resources, so big budget deficits should lead to soaring interest rates; meanwhile, because the supply of goods is limited, large increases in the money supply should lead to soaring inflation. Oh, and cuts in government spending should, if anything, be expansionary, because they both release resources to the private sector and make life tougher for workers who try to live on public benefits.

If, on the other hand, you believe that the problem lies in a shortfall of demand due to the zero lower bound, you believe that government borrowing needn’t drive up rates, because it puts unemployed resources to work; that monetary expansion won’t be inflationary, because the money will just sit there; and that fiscal austerity will be strongly contractionary.

Except that is not what Austrians are saying will happen. I’ve not read a single Austrian commentator who was predicting “soaring interest rates” and while some have predicted a lot of inflation, one has to remember what the term “inflation” means to Austrians versus Keynesians.

To a Keynesian, inflation is an increase in the government’s Consumer Price Index and nothing more. It is a statistic, a weighted average of data points that economists have constructed that supposedly would reflect the economic life of Jane and Joe Average. As long as the CPI is not rising by more than a few percent, to a Keynesian there is little or no inflation.

With the CPI not showing much more than a 2 percent annual increase in its official rate of inflation, Krugman can say that what the Obama administration and the Federal Reserve System are doing is good because it has “stimulated” the economy and not resulted in any problems with inflation.

In fact, Krugman looks at the results of the government’s actions and concludes that it is self-evident that the Keynesian viewpoint not only is economically correct, but also morally correct, as Keynesians actively are trying to put people back to work while Austrians want to wait on the slow, unpredictable market to end the misery. The Keynesian model well may be a crude and giant-sized input-output model with one input (aggregate demand) and one output (aggregate supply), but nonetheless it is easy to explain and easy for many to believe.

As Jeffrey Tucker notes in this article, however, the Krugman caricature of Austrian thinking simply is wrong. First, Austrians do not believe that inflation necessarily is measured in a government statistic; it is the increase of money in circulation, period, and the effects of inflation are not always easily captured in the Jane and Joe Average numbers. Instead, we find streams of money following assets such as stocks today. (The current bull market is touted as resulting from President Obama’s economic genius, just as the stock bubble in the late 1990s was attributed to President Clinton’s savvy. George W. Bush bragged about housing during his administration until the whole bubble collapsed.)

Housing prices are higher than they should be and certainly higher than current economic conditions would reflect, and even though corporate profits are high, the stock market has all of the trappings of yet another financial bubble to go along with the financial bubble that the Fed is helping to create in U.S. sovereign debt. In other words, we are seeing the new money take certain paths that are affecting asset values but not necessarily being reflected in overall consumer prices.

The exceptions are those goods tied closely to commodities, including food, fuel, and, yes, precious metals. Furthermore, as I mentioned earlier, most Americans have seen their real incomes drop substantially; they know they are getting poorer, and most people do not believe the U.S. economy rests on a solid foundation. Tucker writes:

… as Mises would predict, what seems like economic progress is not entirely fake but it comes with a rub. Incomes aren’t really increasing, because capital is not being accumulated. Prosperity exists and continues apace, but it has a very weak foundation. It is nothing more than a “castle in the air,” as Mises would say. (In the original German, the word is Luftschloss, meaning a dream that is not realistic.)

Notice that the scenario that Mises maps out here can include such things as the hyperinflation of history and legend, but it need not. Bad money does damage either way. And the damage is long term — not a crisis tomorrow or the next day, but a long-run effect that slowly erodes the foundation of a growing economy.

This is not to say that monetary expansion has no effect upon consumer or producer prices. Indeed, because Austrians hold to a marginal utility view of money (the expansion of the money stock reduces the value of the marginal unit of money, which forces up money prices) the huge expansions of the dollar as pushed by the Fed are going to push prices higher. There has not been a hyperinflation, however, because most of the increased money stock is in accounts such as bank reserves that have not become actual circulating dollars. This is not the same situation as having the government print dollars that directly go to workers, as was the case in Zimbabwe, Bolivia, and even Weimar Germany.

No, the problems in our economy won’t be “solved” with a giant real wage cut either by the market or by fiat or by a burst of inflation, and neither will they be solved by government borrowing, printing, and the Fed purchasing worthless assets in order to try to maintain “confidence” in financial institutions and in governments.

Krugman may ridicule the Austrian paradigm of sound money, savings, and entrepreneurship, but it works and works well. Writes Tucker:

People can live in a house a long time without paying attention to the reality that the foundation that holds up the building is cracked and rotting.

Right now, most Americans sense that something is wrong but are assured by the political classes and a large number of academic economists like Krugman that insist the economic foundations of this house are solid. At the same time, the very people who voice these assurances are taking the jackhammer to the structure all the while insisting that they are building an economy, not tearing it down.

William Anderson, an adjunct scholar of the Mises Institute, teaches economics at Frostburg State University. Send him mail. See William L. Anderson's article archives. Comment on the blog.

© 2013 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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