Thursday, January 20, 2011

Krugman Misses Point On Capacity & Malinvestments

Paul Krugman argues that the view that much of the boom during the housing bubble represented useless production, and that there thus isn't any excess aggregate supply relative to aggregate demand, is false because regardless of whether it was useful or not, it was still produced.  Therefore he argues that it makes sense to extend growth from that period to estimate "potential GDP".

But even setting aside the general problems with that concept, Krugman's argument contains two more problems.

First of all, industrial capacity has declined in recent years, whereas it during the previous boom expanded. This by itself  clearly suggests that potential output has grown more slowly, or more likely not at all.

And secondly and more importantly, the key issue isn't whether or not it is possible to produce more things, the issue is whether or not it is possible to increase production of more useful things.

And while Keynesians and most other non-Austrians thinks that factors of  production are basically homogenous, in reality they are to varying degree specific to certain lines of production, meaning that when for example people no longer demand new construction, this means that the factors of production that specialize in that can't be used, or at least have a lower degree of usefulness in other areas. This means that the value they can generate is lower than the apparent value they had as malinvestments during the previous boom.

This implies that the capacity to produce things which are still considered useful has likely fallen even more than the official capacity numbers.