Monday, August 1, 2011

The Deepening Depression

William L Anderson
Mises Institute

While Austrians and Keynesians don't agree on a lot of things, there is one thing on which they both seem to agree: the US economy is sinking into the morass of depression. At that point, however, the agreement ends, as the two schools have very different explanations as to why this is happening.

The Keynesians, through Paul Krugman and his New York Times megaphone, have been claiming that the original Barack Obama "stimulus" was too little, and the current emphasis on budget cutting at all levels of government is exactly the wrong strategy. Austrians, not surprisingly, believe that this explanation is nonsense, and dangerous nonsense.

In a recent column, Krugman lays out his thesis, and it is useful, for it truly exposes the Keynesian mind at work, and a Keynesian mind that allows for no other explanations as to what is happening. The problem is — and always will be — a lack of "aggregate demand," and the only solution is for governments to spend as though they have hit the jackpot.

He writes,

The great housing bubble of the last decade, which was both an American and a European phenomenon, was accompanied by a huge rise in household debt. When the bubble burst, home construction plunged, and so did consumer spending as debt-burdened families cut back.

Everything might still have been O.K. if other major economic players had stepped up their spending, filling the gap left by the housing plunge and the consumer pullback. But nobody did. In particular, cash-rich corporations see no reason to invest that cash in the face of weak consumer demand.

Nor did governments do much to help. Some governments — those of weaker nations in Europe, and state and local governments here — were actually forced to slash spending in the face of falling revenues. And the modest efforts of stronger governments — including, yes, the Obama stimulus plan — were, at best, barely enough to offset this forced austerity.

So we have depressed economies. What are policy makers proposing to do about it? Less than nothing.

If anything describes the Keynesian mindset, it is this: spend, spend, spend. It is a simple thesis, one that certainly appeals to politicians, and even to much of the general public, and has dominated professional economic thinking in the United States since World War II. As Krugman states above, households cannot spend what they don't have, and businesses, because they don't see future demand, are not going to invest (read: spend through capital investment — which is always defined by Keynesians as being valuable because of spending, not because of any aspects of capital productivity).

So we are stuck in what Krugman and Keynesians call a "liquidity trap," which Krugman seems to believe ends all other discussion. The notion is that the law of opportunity cost is suspended during a liquidity trap because interest rates are low, resources are "idle," and government can borrow at nearly 0 percent and spend without consuming any resources. As Krugman said in his book The Return of Depression Economics, government spending in this situation can create a "free lunch." (Yes, he actually used that term.)

While most mainstream economists are not willing to engage the Keynesians on the idea of the "liquidity trap," Murray Rothbard did not back away. In his book, America's Great Depression, he takes on the whole notion of the "liquidity trap" head on, writing,

The ultimate weapon in the Keynesian arsenal of explanations of depressions is the "liquidity trap." This is not precisely a critique of the Mises theory, but it is the last line of Keynesian defense of their own inflationary "cures" for depression. Keynesians claim that "liquidity preference" (demand for money) may be so persistently high that the rate of interest could not fall low enough to stimulate investment sufficiently to raise the economy out of the depression.

Rothbard points out a serious problem with that analysis, noting that Keynes never got the theory of interest correct, claiming interest is based on "'liquidity preference' instead of time preference," which then leads to more incorrect conclusions about the state of the economy. Other Austrians have criticized the theory, as well, including William Hutt and Henry Hazlitt.

Both Hutt and Hazlitt took on the whole idea of "idle resources," which is behind the notion that opportunity cost can be suspended during a depression. The idea of idle resources is based on a notion that factors of production are unemployed because of a lack of spending, and that a burst of government borrowing (at nearly zero, which means almost no opportunity cost) will spread to these unemployed assets and put them back to work.

As I noted before, the Keynesian theory is disarmingly simple. Resources are unemployed, so government "stimulates" the economy through more spending; the resources are put to work, and somehow the economy magically sustains itself. On the flip side, Keynesians hold that if new spending does not occur, then deflation will result, making more resources unemployed until ultimately the economy is in a perverse equilibrium in which huge numbers of people are out of work with no prospects for economic improvement.

Read all of it.