In Review: Paul Krugman's New Book

It's a zombie book, that's what kept running through my head as I got deeper and deeper into Paul Krugman's new book, End This Depression Now!,  There are a lot of facts about the recent economic crisis in the book, but it as if there is no heart and soul to the book.

Although he discusses Keynesian theory and other economic theories relative to the crisis, he doesn't once mention Austrian business cycle theory (ABCT). The closest he comes is to a mention of Austrian economics at all is to quote Peter Schiff, who should be considered a financial adviser rather than an economist, and a mention of Ron Paul. (p.150) (He also mentions Schumpeter in a discussion of a Raghuram Rajan FT article) (p204)

But he doesn't come anywhere come close to mentioning Austrian heavy weight theorists such as Ludwig  von Mises or Murray Rothbard. He only mentions Noble prize winner Friedrich Hayek by last name in parenthesis, (p.205) which doesn't even get Hayek into the book's index. It's not like he doesn't mention other theorists, he mentions John Maynard Keynes many times, Milton Friedman, Hyman Minsky and Robert Lucas. It's almost as though he is afraid to mention the Austrian heavyweights. Who knew, Austrians scare zombies?

Aside from the zombie like tone to the book, most informative is that Krugman builds his entire Keynesian theoretical edifice based on a misunderstanding of  a tale about a babysitting co-op. I kid you not, Chapter 2 of his book is all about a babysitting co-op.

More than 20 years ago, Krugman wrote in Slate about this silly co-op story (my bold)

Twenty years ago I read a story that changed my life. I think about that story often; it helps me to stay calm in the face of crisis, to remain hopeful in times of depression, and to resist the pull of fatalism and pessimism.

In other words, for 40 plus years Krugman has been walking around with this story as the base of his economic view, and he simply misunderstands the tale.

This is what I previously wrote about his favorite tale:

 The story was the babysitting co-op story of which [Krugman] writes:

The Capitol Hill co-op adopted one fairly natural solution. It issued scrip--pieces of paper equivalent to one hour of baby-sitting time. Baby sitters would receive the appropriate number of coupons directly from the baby sittees. This made the system self-enforcing: Over time, each couple would automatically do as much baby-sitting as it received in return. As long as the people were reliable--and these young professionals certainly were--what could go wrong?

It is important to understand what is going on here. In a moment Krugman is going to liken this babysitter co-op to the economy. But this is far from the case of what the co-op is, on any scale. In actuality, what is going on here is barter. You watch my kids, I'll watch your kids, with scrip inserted to make sure there is a balance between watching and leaving off. 

So the first important thing to understand is that in Krugman's little world there is no money! Money is a medium of exchange you use in nearly all daily transactions, not a piece of script that can only be used for babysitting purposes. So he is trying to justify the printing of money using a model where there is no money!  

Let's move on. Krugman writes:  

Well, it turned out that there was a small technical problem. Think about the coupon holdings of a typical couple. During periods when it had few occasions to go out, a couple would probably try to build up a reserve--then run that reserve down when the occasions arose. There would be an averaging out of these demands. One couple would be going out when another was staying at home. But since many couples would be holding reserves of coupons at any given time, the co-op needed to have a fairly large amount of scrip in circulation. 

Now what happened in the Sweeneys' co-op was that, for complicated reasons involving the collection and use of dues (paid in scrip), the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple's decision to go out was another's chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further.

In short, the co-op had fallen into a recession. 

First, let's consider this "small technical problem". Krugman doesn't go into details, but for some reason there is an obvious taking away of script from some of the participants. The dues sound like some kind of a tax. The rational conclusion would be, "Hey taxes are bad, they are taking from some and giving to others. If you do it at a high enough rate, you are going to collapse the system". The script system, because of these tax/dues, appears to have pretty much collapsed the co-op. But what is cute is that Krugman doesn't call this tax/dues caused collapse a tax/dues caused collapse, he calls it a recession.

It's Krugman getting really mentally disorderly. These scripts, I emphasize again, are barter tools, not money. The scripts do not have an exchange ratio against all products the way money does, i.e. money is about prices. The scripts simply reflect a call on babysitting services. That's it. A recession is about changing prices. The stock market collapses in a recession, housing prices collapse, prices are too high for some products, causing fewer sales resulting in businesses laying off employees and sometimes failing. How is any of this action reflected in Krugman's babysitting story? The answer is that it is not. 

Yet, Krugman plows along with his model and says that the issuing of more calls on babysitting services is like printing money. But, it is an entirely different thing. If the money supply somehow dropped, prices would adjust downward so that the economy could function. In Krugman's model with script, when the script declines because of dues/taxes, there is no mechanism to adjust the economy, because we are not talking about an economy or a medium of exchange, we are talking only about a script good for one hour of babysitting. Print more calls for babysitting services and, duh, you will get more demand for babysitting services. If you print more money, prices adjust through out the economy having only distorting impact on the economy that favors those who get the new money first. 

Here's another way to think about it. Suppose there was an iPad buyers co-op.  Everyone got 10 co-op coupons that they could exchange for an iPad and the number of iPads in existence match up with the number of coupons . Since few really need 10 iPads, furious trading might occur with the "extra" iPads. Keep in mind this is a closed system, within the co-op. If suddenly through dues or taxation the number of coupons shrinks dramatically, then participants would be much more cautious with the coupons they still held. This is basic marginal utility theory. In the closed co-op system there is less product as coupons are removed. Krugman doesn't get this. He mistakenly views the coupons, which represent supply, not as supply but as money. They aren't, they are coupon calls for product.

In the real economy, products don't disappear during a downturn, what happens is that prices fall. There are not, for example, fewer iPods in the economy, at the start of a recession. But, there is less product in Krugman's closed co-op tale, when coupons are drained.

Bottom line: Krugman, his entire professional life, has been walking around with a faulty theory upon which he has built the rest of his economic theories.

It's resulted in a totally incorrect view of the causes and cures for the business cycle. In his mind, it's all about printing more babysitting coupons. And thus, his zombie book crashes, without a proper base (Austrian business cycle theory.)

Aside from this major error, a fun spot in the book is Krugman pretty much admitting he had no clue the Great Recession was coming. He writes (p.82)

Before the financial crisis of 2008 struck, I would often give talks to lay audiences about income inequality, in which, I would point out that top income shares, had risen to levels not seen since 1929. Invariably there would be questions about whether that meant we were on the verge of another Great Depression---and I would declare that this wasn't necessarily so, that there was no reason extreme inequality would necessarily cause economic disaster. 

Well, whaddya know?

Of course, the extreme inequality comes about because of central bank money printing that firsts finds its way into the hands of a  favored few. That's what happened prior to 1929 and what happened prior to 2008. If Krugman understood ABCT, he would have recognized this as one of the signs. He obviously didn't

On another note, it is interesting to point out that Murray Rothbard considered Milton Friedman essentially a Keynesian when it came to monetary theory:

Extreme trust-busting, egalitarianism, and Keynesianism: the Chicago School contained within itself much of the New Deal program...  The third major feature of the New Deal program was proto-Keynesian: the planning of the "macro" sphere by the government in order to iron out the business cycle. In his approach to the entire area of money and the business cycle – an area on which unfortunately Friedman has concentrated most of his efforts – Friedman harks back not only to the Chicagoans, but, like them, to Yale economist Irving Fisher, who was the Establishment economist from the 1900s through the 1920s.

Thus, it is fascinating that the Keynesian Krugman mentions Friedman in support of his views no less than five times in the book. For example, Krugman writes:.

Milton Friedman...at least conceded that monetary policy could be an effective tool for stabilizing the economy. (p. 96)

Indeed, when Friedman published a paper in 1970 titled "A Theoretical Framework for Monetary Analysis,"  many economists were shocked by just how similar it looked to textbook Keynesian theory. (p.101) 

Never mind Keynes, Milton Friedman has crusaded against this kind of [Schumpeterian liquidationist] thinking. (p.205) 

Thus, most likely unbeknownst to Krugman, he has provided support to the great Austrian economist Rothbard and his view on Friedman as a Keynesian. But that's really the only thing of value in the book.