Krugman never read Hayek

One of the best books ever written by the austrian economist Friedrich von Hayek is, by far, Prices and Production. It was first published in 1931 (the second edition is from 1935) and it’s one of the best presentations of Austrian Business Cycle Theory. A must read to anyone who want to understand the theory. In re reading some parts of it, I have found something interesting.

The keynesian economist Paul Krugman made a famous criticism of the austrian theory in 1998. Last week I was shocked by the fact that Hayek already refuted his criticism in his book. Actually, Krugman was refuted before he was born. 

Krugman's critique in 1998:

Here's the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?

Here is Hayek's response in 1935 (page 271 of the linked book):

But while the nonspecific goods, in particular the services of workmen employed in those earlier stages, have thus been thrown out of use because their amount has proved insufficient and their prices too high for the profitable carrying through of the long processes of production, it is by no means certain that all those which can no longer be used in the old processes can immediately be absorbed in the short processes which are being expanded. Quite the contrary; the shorter processes will have to be started at the very beginning and will only gradually absorb all the available producers’ goods as the product progresses toward consumption and as the necessary intermediate products come forward. So that, while in the longer processes productive operations cease almost as soon as the change in relative prices of specific and nonspecific goods in favor of the latter and the rise of the rate of interest make them unprofitable, the released goods will find new employment only as the new shorter processes are approaching completion.62 Moreover, the final adaptation will be further retarded by initial uncertainty as regards the methods of production which will ultimately prove profitable once the temporary scarcity of consumers’ goods has disappeared. Entrepreneurs, quite rightly, will hesitate to make investments suited to this over-shortened process, i.e., investments which would enable them to produce with relatively little capital and a relatively great quantity of the original means of production.

So that’s why you are not “always” going to have a “corresponding consumption boom”. And that’s also the reason why you would have a rise in unemployment. Notice that Hayek already answered both questions.

Krugman continues:

Most modern hangover theorists probably don't even realize this is a problem for their story. Nor did those supposedly deep Austrian theorists answer the riddle. The best that von Hayek or Schumpeter could come up with was the vague suggestion that unemployment was a frictional problem created as the economy transferred workers from a bloated investment goods sector back to the production of consumer goods. (Hence their opposition to any attempt to increase demand: This would leave "part of the work of depression undone," since mass unemployment was part of the process of "adapting the structure of production.") But in that case, why doesn't the investment boom—which presumably requires a transfer of workers in the opposite direction—also generate mass unemployment? And anyway, this story bears little resemblance to what actually happens in a recession, when every industry—not just the investment sector—normally contracts.

In the previous Hayek's quote there is a footnote number 62. There he said:

62 The reason for this asymmetry between a transition to longer processes of production, which need not bring about any of these peculiar disturbances, and a transition to shorter processes, which will regularly be accompanied by a crisis, will perhaps become more evident if it is considered that in the former case there will necessarily be time to amortize the capital invested in the existing structure before the new process is completed, while in the latter case this will evidently be impossible and therefore a loss of capital and a reduction of income inevitable. (In all these discussions it is assumed that technical knowledge remains the same; a shortening of the structure of production which is due to technical progress has an altogether different significance from that due to an increase of consumption.)

There you have it. Hayek answered Krugman's critique 63 years before. It is irrelevant whether Krugman likes Hayek’s answer or not. The important thing is that, had he read the book, he would never made the questions in the first place. Joseph Salerno is completelly right, Krugman never read the Austrian Business Cycle Theory from its original sources (Hayek, Mises, Rothbard). He just have read the "garden-variety neoclassical theory" from Haberler.

You can add this to all other evidence (here, here, here, here, here, here, here, here and here) which demonstrate that Krugman never understood what he was criticising.

Social Failurecracy

It all began with Krugman, who made a post attacking Mises based on a "critique" by the blogger "Lord Keynes".

Salerno, Murphy and Hammond have offered good answers to Krugman. 

If you wanna see a real good discussion on wage rates and the Great Depression, see here. But in the meantime let's see some of LK's arguments.

LK: "The solution, then, for Mises was eliminating unemployment relief (presumably forcing the unemployed to starve and accept lower wages)..." 

The word "starve" was deliberately chosen by LK in order to arouse the indignation of the reader. Aparently he cannot "criticise" someone without appealing to this kind of tricks. Had LK read the article completely, he could have seen that Mises explains why workers would not "starve" necessarily because market wages cannot fall indefinitely: "This in no way means that the market would tend to push wage rates down indefinitely. Just as competition among workers has the tendency to lower wages, so does competition among employers tend to drive them up again. Market wage rates thus develop from the interplay of demand and supply." And even assuming LK did read it, it would mean that he deliberately misinterpreted what Mises wrote and his "criticism" would be worthless.

By the way, I must also emphasize that Mises did not advocate a uniform-in block fall in all wage rates, but for freedom in wage rates determination. Free wage rates do not mean falling wage rates. Some of them will certainly fall, but others may not do so and others may even rise: "However, it is not a question of reducing wage rates. This bears repeating with considerable emphasis. The problem is to re-establish freedom in the determination of wage rates.". I say this because people like Krugman has demonstrated that they have never read Mises or Hazlitt.

LK: "How else could such suppression of trade unions be realistically achieved except by government coercion?"

Apparently LK cannot think in other solution for problems than government coercion, and he projects that kind of behaviour to other people. Even to those, like Mises, who emphatically and explicitly had rejected government solution in the quotation LK himself has used: "formation of wage rates should be hampered neither by the clubs of striking pickets nor by government’s apparatus of force"

LK: "This is the point in the essay where Mises may as well have been winking at his audience to indicate what his words imply: that governments should break up and repress unions and restore labour market freedom."

I thought that this kind of empty rhetoric was only a feature of the left-wing writers here in southamerica, but I see that the Left is chatterbox at international level. Mises is clearly talking about violations of worker's rights to work ("those who molest persons willing to work") and destruction of property owned by the firm ("destroy machines and industrial equipment in enterprises that want to hire strikebreaker"), that two things are legal protective tasks that any government in the classical liberal tradition (or in the statist keynesian fantasy) must do, i.e. protect property and rights. LK has misinterpreted with his own words what Mises has clearly said. His caricaturization of Mises as a kind of "evil hater of unions" is based on nothing but an hallucination of his mind. Anyone, not biased by a subjective bad faith, would have noticed that there was nothing wrong in describing what a government in classical liberal tradition must do: protect rights (of workers to work) and property (of the firm).

All this is part of LK's desperate attempt to fuse Mises with fascism. Of course that's a big lie, a lot of people and I myself had refuted this and other attempts to do that fusion.  As "Lord Keynes" cannot even assert that Mises directly supported fascism (he lacks of evidence to do that), all he can do is to try to leave in his readers' mind the association he is unable to prove: "Mises the fascist". In the same way and using his own way of arguing, I could point out the reader the introduction of General Theory written for the totalitarian Nazi Germany of 1936 in which Keynes assured us that "The theory of aggregated production, which is the point of the following book, nevertheless can be much easier adapted to the conditions of a totalitarian state...". Of course I would never do that because I do not use LK's bad tricks, but LK's double standard would never let him say that this statement by Keynes could be interpreted as a positive comment on German totalitarianism. 

LK: "The reason is that capitalist investment and demand for labour is not a simple function of the wage rate or interest rate, as naïve, ignorant and incompetent Austrian ideologues like Mises thought, and many still think."

1) Note that it is false that Mises takes investment as a "function" of something, austrians like Mises explicitly rejected expresions in terms of rigid determined "functions" or "propensities" as keynesians do. (Of course this does not apply to those austrians who, in order to be interpreted by mainstream audience, use those terms.) 

2) As the real Lord Keynes, the blogger falls in the same old errors that Hazlitt showed:

"For that chapter is concerned with the effect of expectations merely on output and employment. Keynes should have recognized also that expectations are embodied and reflected in every price—including the price of the raw materials that the individual businessman has to buy, and the wage-rates that he has to pay... one of Keynes's own principal errors in his discussion of the relation of the marginal efficiency of capital to interest rates is his failure or refusal to recognize that current interest rates are also determined in large part by expectations regarding the future... The rate of interest is involved in every price in which the time element enters. The price of a house is the discounted value of its future income. As Irving Fisher has insisted: "The rate of interest is the most pervasive price in the whole price structure.""

So for LK, one of the most important prices of the whole economy, the interest rate, is unimportant. The capital value at any time is based on expectations of future rental prices discounted by a rate of interest. In other words, the present value of an investment project is completely dependent on the size of expected cash flows, the timing of those expected cash flows and the rate of interest. 

So we have LK saying that investment 1) involves "the expectations of business people" and 2) "is not a simple function of the wage rate or interest rate". Any individual entrepreneur must take in account expected wage rates (and other expected costs), expected price of product and market interest rates which also have expectations on them. Then LK has denied that expectations (expected interest and wages) have an important role on investment and at the same time he has asserted that expectations have an important role on investment. Wage rates and interest rates are important part of and are determined by expectations, but LK has wrongly understated them.    

3) Entrepreneur's investment is determined in last instance by price spreads i.e. the difference between expected costs (included the interest rate) and the expected future price of the product. An entrepreneur is concerned about his own product/s or service/s, not by the aggregate "level of demand for output". He sees his parcel, his own business and clients, the environment where he moves, etc. For individual entrepreneur the expected and particular price of product (which is not determined by the firm, but only set waiting for consumers to pay) is also very important, not only the quantity firm is planning to sell. Once again the aggregate biased way of thinking of keynesians made them fall into error. For a refutation from the real Lord Keynes see here. 

4) An investment is done because people expect it will yield some profit or return (future consumption) that will be greater than otherwise. Obviously since investment means looking at the future, the entrepreneur faces uncertainty (this is nothing new nor original, it has been stressed by austrians for decades, nor is any kind of concession to LK). The subjective utility of future investment is discounted by uncertainty. Time preference also is very important in deciding whether or not invest, people balance additional returns vs consume at present. Particular time preference and particular uncertainty of future faced by individual entrepreneur limit investment. 

But even though uncertainty can delay investment, expectations alone are not the ultimate limit for entrepreneurs' activities. Even if there is a sudden anomalous and over-exaggerated rise in positive expectations, entrepreneurs will face a market "natural break". Assuming no change in quantity of money and credit, as long as all or a great majority of entrepreneurs want to start new projects or to extend the existing ones, they will need more of their specific kinds of labor and raw materials. But as all or a great majority of entrepreneurs want a limited quantity of factors, they will have to pay a higher price. And not only that, the funds needed to finance their ventures must come from somewhere, so they will push up the market rate of interest (this is not necessarily the "loan rate" of interest). So exaggerated expectations will start to diminish as the difference between expected costs (included interest rate) and expected future price goes down.

LK: "Mises was blissfully unaware of what many economists were to discover in the 1930s and what Gardiner Means had already discovered: that real world price rigidities are mainly caused by the private sector itself, because most businesses adopt relatively inflexible mark-up/administered prices."

A totally false statement. Mises and other economists already knew by 1912 that "fixed prices" "play a large part" in selling policies. However Mises was not so ignorant to believe that those firms determine prices, because they just set the price. LK's mistake is double: 1) deliberate ignorance about Mises' 1912 book and 2) deliberate ignorance that Gardiner Means' "theory" is false in theoretical (as Machlup and others demonstrated) and empirical (as Stigler and others demonstrated) grounds. I said "deliberately" because LK has read Mises' book and he surely has heard about the bibliography of the debate.

LK's comments about "debt deflation" only demonstrate how bad and fallacious his "business cycle theory" is because, as I explained here, it has been demonstrated that debt-deflation is just a special case of a more general process: malinvestment liquidation. 

Finally about the alleged "refutation" of ABCT by Sraffa, see here for my short explanation about why that is not true when it's applied to Mises. And also see here, here and here to see the full story with all quotations and evidence that demonstrate that misesian ABCT is totally immune to all accusations about interest theory and policy issue raised by Sraffa against Hayek.

As we see "Lord Keynes"' criticism falls by its own weight. And Krugman's reliance on such bad arguments one more time demonstrates why an increasing number of people, including me, do not and cannot have any respect for him and his NYblog.

The Interest Rate Fallacy: 49 Years Before Friedman

A delicious way to settle the
Vienna vs Chicago dispute

The interest rate fallacy means that it is a fallacy to look only to the state of interest rates as an indicator of whether or not the central bank (CB) has embarked upon an easy monetary policy. Because after a certain time period, CB can affect interest rates indirectly via inflationary expectations. For example if CB embarks upon an expansionary monetary policy and agents fully anticipate a rise in prices as consecuence of that, then the easy monetary policy will rise interest rate rather than lower it because of the inflation premium included in nominal rates. Conversely a tight monetary policy will lower interest rates if a “deflation premium” is added into nominal interest due to deflationary expectations. In this circumstances if you look only at the interest rates, you just don't know if the CB is on an easy or tight monetary policy. After a certain time period the direction of interest depends on inflationary expectations of people. The quantity of money and credit is a much better indicator. 

This discovery is usually credited to Milton Friedman, however Mises almost 50 years before him said a similar thing:

Mises (1949): "[A]t the very beginning of a credit expansion no positive price premium arises. A price premium cannot appear until the additional supply of money (in the broader sense) has already begun to affect the prices of commodities and services... The gross market rate would have to rise on account of the positive price premium which, with the progress of the expansionist process, would have to rise continually... Arithmetically, the gross rates of interest are rising above their height on the eve of the expansion."

Friedman (1998): "Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates."

Mises (1949): "It is the continuous increase in the supply of the fiduciary media that produces, feeds, and accelerates the boom. The state of the gross market rates of interest is only an outgrowth of this increase. If one wants to know whether or not there is credit expansion, one must look at the state of the supply of fiduciary media, not at the arithmetical state of interest rates."

Friedman (1998): "The Fed pointed to low interest rates as evidence that it was following an easy money policy and never mentioned the quantity of money. The governor of the Bank of Japan, in a speech on June 27, 1997, referred to the "drastic monetary measures" that the bank took in 1995 as evidence of "the easy stance of monetary policy." He too did not mention the quantity of money."

There we have both Mises and Friedman saying that if you want to see whether or not the CB is expanding credit, then you must look at the money supply rather than the nominal rate of interest.  

In Lecture 5 of Buck Hill Falls in 1955, Mises made this excellent clarification of ABCT: 

"The first thing I want to mention in this regard is that people say: "You ascribe the emergence of the boom to a lower rate of interest, to the fact that the rate of interest is lower than it should be. But if you look at the history of the business cycles over the last hundred years, you will discover that one of the characteristics of the boom periods is that there is an increase in interest rates. Therefore, your first assumption is wrong."

Now this objection is due to the fact that people talk about a higher or lower rate of interest simply from the arithmetical point of view. This objection was very carefully criticized by Wicksell. People say that 5% interest is higher and 4% is lower. True! But arithmetic has nothing to do with the problem. The question is whether the rate of interest charged by the banks is above or below the "equilibrium" rate or, as Wicksell said, the "natural rate of interest."… At the beginning of the boom, there was a certain basic, "originary," rate of interest. However, in adopting an easy money policy, the banks made loans below this originary rate of interest, creating additional money precisely for the purpose of lending. Then prices started going up… With an additional quantity of money in circulation, there is a tendency for prices, and also interest rates, to rise. If a borrower expects prices to rise, he values goods and money in the present relatively higher than he does goods and money in the future. When evaluating present goods as against future goods, people take into consideration the anticipated higher prices of future goods. As a result, they are willing to pay a premium to have things now, to pay a higher rate of interest, to obtain things sooner rather than later. Thus, there is added to the pure, originary, rate of interest, a "price premium."… Therefore, in a boom period the market rate of interest must necessarily go up and up, as it contains now not only the originary or pure interest rate but the price premium besides. The interest rate may go up and up in a boom and yet it may still remain below the rate it should have attained under these conditions. A higher money rate of interest doesn't mean that the real, the pure or originary, rate of interest is higher. Nor does it mean that the policy of easy money has been abandoned. Nor that the banks are trying not to expand too much; they may just be trying not to increase too much the spread between the lower rate they are charging and the market rate they would have charged if they were not expanding credit. Therefore, a higher interest rate in the course of the boom doesn't mean that the real interest rate is higher."

And this is the point. Even if you see interest rates rising during the boom, that doesn't mean that banks abandoned the credit expansion. As I already explained here (short explanation) and here (full explanation), the development of the malinvestment boom is perfectly compatible with a rising interest rates. The lowering of the rate of interest is a relative one, relative to the rate of interest that would have prevailed without credit expansion. This lowering can manifest itself on an arithmetical lowering or maybe by keeping the rate constant or by increasing it (less than it would have increased). Even if the rates of interest are increasing, the boom can continue as long as there is credit expansion. That injection of credit makes the rate be below what would have been without the injection. That's why, for example, the 2002-2007 boom continued in the US even when interest rate (FEDFUNDS) started to rise in 2004, because there was still some availabilty of credit (an increasing YoY rate of growth of M2 to give an example).