Sunday, December 28, 2008

Krugman, Teetotaller Hangovers & Austrian Theory

Paul Krugman is at it again, denouncing what he calls the hangover theory, which is to say his straw man version of Austrian business cycle theory.

He first claims that Austrian theory can't explain why there isn't increased unemployment during the boom phase or why almost all sectors experience difficulties during the slump, which is not true, as I pointed out in a previous post.

Krugman proceeds to note that in the top ten of states that experienced the biggest housing bubbles along some of the states that experienced the biggest housing bubbles, such as California, Nevada and Florida, are states like Georgia, Alabama and the Carolinas which supposedly didn't have a housing boom, something which he appears to regard as evidence against "the hangover theory". But first of all, it is not really true that there were no housing boom in the states he points too, at least no cyclical one. Because of slower population- and economic growth their structural growth is slower than in for example Nevada, meaning that even if their aggregate housing boom were modest, it could still be a cyclical element in that boom.

But more importantly, it is not inconsistent with Austrian theory to expect other states than the ones with the biggest bubbles, like California, Florida and Nevada to suffer from the bust. It would only be inconsistent if states had been economically isolated from each other with no trade or capital flows across the states. But in reality there is a very high level of economic integration between states. And as many companies in for Georgia were selling goods to for constructors and others in Florida, they will naturally take a hit if their customers stop buying their goods. Their investment in output meant to serve customers profiting from the housing bubble were as much malinvestments as the houses built during the housing boom.

Similar reasoning can be applied to explain the apparent mystery of why not just countries with big housing bubbles, like the U.S., the U.K. and Spain are affected by the current global downturn, but also countries with weak housing markets like Germany and Japan are affected. The Economist referenced the problems of Germany and Japan with Krugman's "hangover theory" term, as "the teetotaller's hangover".

As Germany and Japan borrowed the bubble countries the money they needed for the housing boom and centered their economies on selling goods to bubble countries, they are of course affected when the booms turn into a bust. Germany's decision to raise its value added tax (which taxes imports, but not exports) and at the same time lower its payroll taxes (which taxes exports, but not imports) in an attempt to increase its export dependence don't look that smart now. This is also aggravated by exchange rate effects in the form of the extreme strength of the yen, which are knocking out even many Japanese exporters that might have been able to survive the general slump alone, as well as the extreme weakness of the U.K. pound, which are hurting German exporters in particular.


Blogger Vijay said...

And as any student of Austrian economics knows, you can't prove anything by citing some statistics, or pointing to a historical event. Yet this is how all these neoclassical fools think economic theory can be derived. They don't even have the rudiments of epistemology to recognize their economic theories are built on sand.

2:08 AM  

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