Thursday, February 3, 2011

Paul Krugman Becomes an Austrian Economist (by two degrees of inflation separation)

The most reasonable way to interpret Paul Krugman's latest post, Inflation and Stock Prices, is to view it as a move toward Austrian Business Cycle Theory.

Although he couches his post in terms of aggregate demand, his chart is the real tell. It tracks for a very short period, the relationship between inflation expectations and stock prices. Viola, they to correlate perfectly.

Now, Krugman suggests that inflation expectations is the driver of stock prices here, but inflation expectations are mostly based on prior price inflation, so it is not a great leap to say price inflation is behind a climb in stock prices. But, of course, price inflation is generally caused by monetary inflation. Thus, Krugman is only two (minor) degrees of separation away from pointing out that monetary inflation drives stock prices higher--which is exactly the Austrian argument.

Austrian's argue that monetary inflation via a central bank directs funds to the capital goods sector, which includes the stock market. Thus driving up stock prices.

Krugman is, thus, through a roundabout manner not too far from supporting the Austrian view of the business cycle. 

One short note on Krugman's chart. This is a very short-period for which he is showing data. Aside from the methodological problems of empirical study to prove anything in economics, the correlation doesn't hold as strongly over longer periods. This should not come as a surprise since there are multiple factors working on price inflation, stock prices etc., at any given time. It appears that the period, 2003 to early 2011, is a period when the "pure" inflation factor  can be seen in the data, without much noise from other influences.


  1. Krugman's definition of inflation is different from the Austrian definition. Krugman looks very narrowly at price fluctuations on certain goods. Sometimes he looks at the very volatile headline inflation. Sometimes he looks at the unresponsive and flawed core inflation. That's all based on CPI's BS formulas and they're all backwards-looking metrics.

    So now he's finally looking at inflation expectations. Seriously, for the first time Krugman is even trying to compare apples-to-apples. Stock market is very much forward-looking. So it only makes sense to compare it to another forward-looking signal.

    BTW, congrats on exceeding 2 million page views.

  2. Here's Krugman becoming more Austrian by one degree of seperation:

    " experience is that many misunderstandings in economics come about because people don’t have in their minds any intuitive notion of what it is they’re supposed to be modeling."

    But he separates himself when he says that he has "nothing against mathematical models and econometrics."

    Almost there!