Mark Thoma vs. The Economist
1. I disagree that we need recessions to have a dynamic economy. Equilibrium means (in simple terms) "no tendency for change" and there is nothing inconsistent with having a constant flow of entering and exiting firms at equilibrium.
When profits are high - as in the traditional price signaling story - there is a rush to enter industries, but the trick is to get there first and take some of the profits before others beat you to it, innovation and technological change are not so important. There are lots of profits to be had by entering with existing technology so, while it does allow the installation of the best and latest technology, there's no strong pressure to innovate. In fact waiting until there is an innovation could be costly.
It's when conditions are tight, i.e. when everyone is making close to zero economic profit, that new cost saving or demand enhancing technological change will pay off. If you have a better product or lower costs than rivals, then you will gain an edge and realize profits. The only way to get ahead is to build a better mousetrap. Sure, conditions will be tight in recessions - that's the traditional creative destruction story - but things are tight in a competitive equilibrium too and the pressure to innovate does not disappear just because the economy is operating at full employment...
...I am not an Austrian economist and I don't play one on the internet, so I won't claim to be able to recite what Schumpeter (or anyone else in the Austrian camp) said about this on a particular page of one of his books, so maybe someone who is an adherent to this "we need business cycles" approach can explain why we cannot wipe out the inefficient while remaining at or very near full-employment.
First, while Schumpeter is an Austrian by nationality, he is not usually considered to be part of the Austrian school of economics, as are for example Carl Menger, Ludwig von Mises, Friedrich Hayek, Murray Rothbard and George Reisman (the latter two aren't even Austrian by nationality). So I won't try to defend Schumpeter's arguments. But in the Misesian version of the argument, a lot of inefficient companies are being artificially sustained through monetary expansion. In order for factors of production to move on to more efficient companies, these inefficient companies have to be destroyed. This requires tighter monetary conditions, which together with the usual time lags in reallocation in resources will produce a short-term decline in production (aka a recession).
2. Overproducing houses is not like overproducing goods that cannot be stored, i.e. perishables. When too much popcorn is produced relative to demand, it goes to waste. Resources that could be used elsewhere are wasted forever since the excess can't be frozen or stored for the future (or at least assume so for the purposes of illustration, there is that stuff in movie theaters). With houses, there is an intertemporal shift in resource use, but since houses don't spoil in a short period of time, and because people will continue to demand them in the future, overproduction today will result in underproduction tomorrow. The houses were built too soon, and that's an efficiency loss because we gave something up, but when we produce less houses later we can recover (some of) the goods that were lost (too many houses and too few cars in year one, but in year two it's the opposite, too few houses and too many cars relative to the no distortion outcome). In the case of popcorn, since it couldn't be stored, lack of storage means we didn't have the opportunity to produce less later, so there is no way to make up for it, even in part, later on.
That is to say, I hope we don't "creatively destroy" the houses that were (over)built. Sure, some can be creatively transformed into restaurants, business offices, etc., to attenuate the misallocation in the short-run, but there's no need to tear them down and replace them. With time, population and demand will grow, and the houses will be filled. Hula hoop factories needed to be creatively destroyed, they needed to be torn down and replaced - it's unlikely demand will return in the future so having those factories around would be a waste, they would never be re-opened - but houses are not hula hoops. With houses, there is no need to "purge the excesses of the previous boom," just wait for population to catch up (and would it be so bad to have low cost housing available in the interim?).
No, the houses need not be destroyed, particularly not in areas where there are positive population growth. In those areas, demand should indeed catch up-at least in that famous long run where Keynesians say we are all dead. There could however be alternative uses for the land which produces a higher value.
And more to the point, what needs to be destroyed are again not necessarily the houses per se, but the companies, building projects and jobs which built the houses. While the houses perhaps need not be destroyed, as the past building of them are sunk costs, what should be eliminated is any further waste of resources by building more of them. In a world without any adjustment costs, that wouldn't cause any recession. But in a world with adjustment costs (such as the one we're living in), it will.
3. I don't understand the reasoning that says the Fed should not stabilize the economy because it will "create a much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the Fed can prevent any future recession."
The reasoning is that if we stabilize the economy, people will then believe recessions are impossible (or underestimate their likelihood) and make bad decisions, so we shouldn't stabilize at all.
People who believe the Fed can prevent all economic fluctuations will be, so to speak, "creatively destructed" the first time there is a recession. But to refuse to stabilize the economy to the best of our ability because we are afraid people might misperceive the degree of stability that is attained seems misguided to me. I would have thought an Austrian response would be to do what's best for the economy and let those who misperceive be weeded out by the market process (or better yet, that they become informed about the true risks - this is a market failure from lack of information and while I'm pleased to see The Economist acknowledge markets can fail, the solution is to provide the information, not to refuse to stabilize).
The only thing right in this part is that first statement about not understanding the argument. So let me explain it to Thoma and others who don't understand. If the Fed through lower interest rates and the implicit or explicit promise of a bail out encourages asset price bubbles and the excess debt and wasteful over-investments, this creates a situation where such behavior is profitable for the investor-but damaging to the overall economy. This is no different from how say massive subsidies of certain farm products makes it profitable to farmers to over-produce but damaging to the overall economy.
This is certainly not a case of "market failure", as the government in the form of the Fed has knocked out the market's weeding out mechanism.
Finally, I note that Thoma fails to comment at all on one of the most important arguments from The Economist: namely, the need to reduce imbalances such as a too low savings rate and excess borrowing.