Sunday, December 18, 2011

More Krugman Konfusion

Paul Krugman wrote recently in a post at the NYT:
OK, strictly speaking the time hasn’t run out — we could, I guess, see an explosion of inflation next year. But with commodity prices down, wages going nowhere, and the dollar actually strengthening against other currencies, it’s kind of hard to see where that’s supposed to come from.

Look, the Austrian/Ron Paul types made some very strong predictions about inflation — and rightly, given their model of how the world works. In their version of reality, it really isn’t possible to triple the monetary base without dire effects on the price level. In my version of reality, of course, that’s not only possible but what the model predicts in a liquidity trap.

So since we did indeed triple the monetary base with nothing much happening to inflation, the right lesson to draw is that their model is all wrong.

This is simply wrong. There is no Austrian economist that has contributed to the development of Austrian business cycle theory, who discussed the monetary base as the figure to watch in determining price inflation . In the camp of contributors, I include Ludwig von Mises, Friedrich Hayek and Murray Rothbard.

Indeed, Rothbard even understood the dangers of looking just at the monetary base, before Fed chairman Bernanke started paying interest on reserves. In his book, The Mystery of Banking, Rothbard wrote:
The numerous problems of new bank instruments and how to classify them, as well as the multifarious Ms, have led some economists, including some monetarists, to argue quite sensibly that the Fed should spend its time trying to control its own liabilities rather than worrying so much about the activities of the commercial banks. But again, more difficulties arise. Which of its own actions or liabilities should the Fed try to control? The Friedmanite favorite is the monetary base...Looking at the aggregate figure of the monetary base cloaks significant changes in the banking picture.
If Rothbard was suspicious of the monetary base, as a means for measuring money supply, before the advent of interest being paid on reserves, he most assuredly would be even more suspicious now.

Now, in the post, Krugman references Peter Schiff, but I consider Schiff a popularizer of Austrian theory and not someone who has expanded thinking in the area of business cycle theory. I don't listen or read Schiff that much, perhaps Krugman does, so maybe he has heard Schiff say something about the monetary base. But those that developed Austrian business cycle theory never focused on the monetary base. Indeed, in the quote above, Rothbard disses Friedmanite focus on the monetary base.

In other words, Krugman just doesn't know what the hell he is talking about.

As for the Austrian School view on what causes price inflation, I am writing up a full commentary on that which I will most likely publish on Monday, so I won't get into that here.


  1. Was Krugman talking about reality when he predicted QE2 would not increase commodity prices unless demand was stimulated? Or that any of the stimulus attempts would work? Or that TARP was necessary? Or that we would have to worry about deflation now? Or that the earthquake in Japan was 'good' for the economy? Or that in 2007 he didn't know if a recession would take place?

  2. I do read and listen to Peter Schiff...He's sharp as a tack. However, while one can tell that he's been greatly influenced by Austrian Economics, I would not call him an "Austrian Economist".

    There have been times (though they're rare) that I've heard him either stumble or give a non-Austrian response to a question. Most recently, I heard him debating with someone on why government spending is not "investment". Schiff was right in saying that it is not, but had a hard time explaining why. Rothbard would have had no trouble at all.

    In my opinion, if someone was genuinely attacking the Austrian School, they would pinpoint their attacks against Misesians & Rothbardians. Otherwise, if they're going after the likes of Peter Schiff, they're mischaracterizing & just looking for a weak link.

  3. I'm sure when prices collapse in the next few months, Krugman will claim victory but for all the wrong reasons and even worse it will set in motion the justification of a massive QE3 effort to re-inflate the global economy. What Krugman does not discuss is that much of the money created so far has remained at the fed or is sitting in corporate and individuals investment accounts. So long as the money stays static, of course there will be no hyper-inflation. But, neither Krugman nor Bernake have any idea how long that money will stay static.

  4. Mr. Rossini,

    I agree with you on Schiff. There is no doubt that Peter is highly influenced by Austrians, but I have also heard him take completely non-Austrian stances on some issues. In fact, usually when he does stray from Austrian ideas he is taking more of a supply-side stance. I mentioned this a few months ago here and people got all pissy about it. Hey, I like Peter and I have followed him for years-- I even donated to his campaign-- but if you're going to criticize Austrian econ, Peter is a weaker target than Rothbard or Mises.

    If anything, Peter is more like an introduction to general Austrian concepts.

  5. Good point Chris. Peter is not an economist and should not be presented as such. He's a hedge fund operator and like many, he leans towards the Austrian understanding of the business cycle. In my view, Krugman's argument really boils down to is timing, which is something the Austrian school has never really focused on.

    The real weakness in all schools of economic thought is that none address the global economy or essentially a floating currency exchange rate system which makes it possible for capital to flow in or out on a whim. All of the economic theories subscribed to today (including AE), were created when there was a hard money system and a fixed exchange rates. Bad fiscal and monetary policy decisions could be isolated under that system and thus there was no need for a global model. Capital also had a much harder time fleeing under that system as well. This is also why when the Fed creates new money it may not necessarily create inflation in the US but instead create it where ever the capital is flowing at that time.

  6. I was under the impression that the liquidity trap was already debunked? No reason for me to debunk it when Hazlitt and Rothbard already articulated it wonderfully.

    Henry Hazlitt in a failure of new economics:
    It is not helpful to explain interest rates as "the reward for parting with liquidity," any more than it would be to explain the price of tomatoes or a house as the "reward"to the buyer for parting with cash for them. Without previous
    saving, moreover, there can be no 'liquidity" to part with. If Keynes's theory of interest were right, interest rates would be highest at the bottom of a depression and lowest at the peak of a boom, which is almost precisely the opposite of their actual tendency.
    Keynes is wrong in regarding money as "barren"; it is a productive asset, and productive in the same sense as other assets.
    Keynes is also wrong in regarding interest as a "purely monetary" phenomenon. His fallacy consists in assuming that because monetary factors can be shown to affect the rate of interest, "real" factors can safely be ignored or even denied.

  7. and again with ROthbard.
    Murray Rothbard in Americas great depression:
    The ultimate weapon in the Keynesian arsenal of explanations of depressions is the “liquidity trap.” This is not precisely a critique
    of the Mises theory, but it is the last line of Keynesian defense of their own inflationary “cures” for depression. Keynesians claim that “liquidity preference” (demand for money) may be
    so persistently high that the rate of interest could not fall low enough to stimulate investment sufficiently to raise the economy
    out of the depression. This statement assumes that the rate of interest is determined by “liquidity preference” instead of by time
    preference; and it also assumes again that the link between savings and investment is very tenuous indeed, only tentatively exerting
    itself through the rate of interest. But, on the contrary, it is not a question of saving and investment each being acted upon by the rate of interest; in fact, saving, investment, and the rate of interest are each and all simultaneously determined by individual time preferences on the market. Liquidity preference has nothing to do with this matter. Keynesians maintain that if the “speculative” demand
    for cash rises in a depression, this will raise the rate of interest. But
    this is not at all necessary. Increased hoarding can either come
    from funds formerly consumed, from funds formerly invested, or
    from a mixture of both that leaves the old consumption–investment
    proportion unchanged. Unless time preferences change, the
    last alternative will be the one adopted. Thus, the rate of interest
    depends solely on time preference, and not at all on “liquidity
    preference.” In fact, if the increased hoards come mainly out of
    consumption, an increased demand for money will cause interest
    rates to fall—because time preferences have fallen.
    In their stress on the liquidity trap as a potent factor in aggravating
    depression and perpetuating unemployment, the Keynesians
    make much fuss over the alleged fact that people, in a financial
    crisis, expect a rise in the rate of interest, and will therefore
    hoard money instead of purchasing bonds and contributing toward
    lower rates. It is this “speculative hoard” that constitutes the “liquidity
    trap,” and is supposed to indicate the relation between liquidity
    preference and the interest rate. But the Keynesians are here
    misled by their superficial treatment of the interest rate as simply
    the price of loan contracts. The crucial interest rate, as we have
    indicated, is the natural rate—the “profit spread” on the market.
    Since loans are simply a form of investment, the rate on loans is
    but a pale reflection of the natural rate. What, then, does an expectation
    of rising interest rates really mean? It means that people
    expect increases in the rate of net return on the market, via wages
    and other producers’ goods prices falling faster than do consumer
    goods’ prices. But this needs no labyrinthine explanation; investors
    expect falling wages and other factor prices, and they are therefore
    holding off investing in factors until the fall occurs. But this is oldfashioned
    “classical” speculation on price changes. This expectation,
    far from being an upsetting element, actually speeds up the
    adjustment. Just as all speculation speeds up adjustment to the
    proper levels, so this expectation hastens the fall in wages and
    other factor prices, hastening the recovery, and permitting normal prosperity to return that much faster. Far from “speculative”
    hoarding being a bogy of depression, therefore, it is actually a welcome
    stimulant to more rapid recovery.

  8. When has any Austrian ever said that the monetary BASE caused inflation? People have said that the bigger base would allow for new loans which would cause inflation if they occurred. Some may have predicted that the new loans would be made sooner than what has actually happened and/or in larger amounts. That has nothing to do whatsoever with Austrian theory and is nothing but a fact-based prediction based upon anticipating unpredictable and ever-changing human behavior.

    Krugmanites must mislead because they cannot win the debate on the merits.

  9. "The dollar strengthening against other currencies" - this is kind of a stupid argument since the dollar only has only maintained its value against the Yen because of Chinese inflation (which will soon lead to a major correction), and the dollar only maintains its value against the Euro bc of their sovereign debt issues right? I mean, once the ECB formally announces bond-buying or people realize it's being done in a circuitous manner, the value of the Euro will increase (in the short term; long term we know this will be bad for the value of the Euro). What has changed about the dollar that has bolstered its value and made Treasuries "safe investments" - - nothing.

  10. @Frank,
    Wow, great stuff about capital flight. Light bulb went off here. Thanks!

  11. I look forward to monday's article about what causes inflation.

    Here are my comments about Krugman's post:

    1. We are experiencing inflation but its not being calculated

    2. If the banks started lending, which they are not, then we would see a pickup in inflation.

    3. Austrians do not believe the base is good measure for predicting inflation.

    4. With a burst in the real estate bubble, inflation will not accelerate until the effects have worked through he system. This will take time.

    5. The increase in the monetary base saved the banks not the people who owned mortgages. The people who had the mortgages took the fall and lost their homes. (BTW, I would not have bailed out the banks nor the home owners; both were complicit in the bubble) However the way it was done it was a major redistribution of wealth from the 99%, the homeowners, to the 1% the banker and investor class.

    I may be wrong. I would love to hear comments on the above.

  12. Frank, AE actually does account for floating rates and fiat monies. Mises' 'Theory of Money and Credit' is a good example, and it was one of his earlier works. Sure, he never specifically discusses our current global monetary framework as it exists today, but he did discuss all of the aspects that are present in our current monetary framework.

    I agree with the heart of your post, I just disagree with the idea that AE hasn't addressed these issues. While it has been a while since I have read it, I specifically remember making very important connections to our current monetary system.

    Just as a side note:
    A few months ago I went on an email journey to ask economists about book recommendations to better understand international finance and international debts. Nobody could really give me a definitive answer and some had expressed interest in actually writing such a thing (because it doesn't really exist). However, it has recently occurred to me that Mises' 'Theory of Money and Credit' is probably the answer that I was looking for. I remember making certain connections to current global monetary realities when I first read it 3-4 years ago, so I imagine that I will be able to more fully understand it upon a second reading and that those "connections" will be more fully realized.

  13. As a non-credentialed, self-educated reader of Wenzel and others - like Schiff - I do notice a few things. First and foremost, most economists do a crappy job of explaining the FED, how it creates it increases the monetary base and then how banks in time increase the money supply through fractional reserve lending. (I hope I've not completely butchered the facts myself).

    Guys like Wenzel are careful to distinguish between the monetary base and the money supply. It takes time to do this, and I appreciate it.

    The difference between the two is regularly ignored...used interchangeably by lots of people. I've heard "monetary supply" come out of fairly smart guys' mouths...Schiff, Ron Paul, etc. It's annoying, but I hardly believe it's reason to get cranky. Guys like Schiff and Paul have done a lot to bring Austrian ideas to the public (IE me!), and they have only a sentence or two to make very difficult points on TV shows that are geared toward soundbites and tag lines. And so I have great appreciation for these guys as well as the more thorough and careful Wenzel's of the world.

    As a novice Wenzel reader, I see the mistake (monetary base/money supply) to be pretty serious, and should be addressed. Regular Americans out there watching the boob tube and reading articles on the internet are starting to believe there, in fact, is no downside to radical interventions of the Federal Reserve.

    I'm also looking forward to Wenzel's Monday article and will distribute it to my network.

  14. Joseph Fetz:

    Chapter 4, 5 & 6 of Jesus Huerta de Soto's 'Money, Bank Credit, And Economic Cycles' seems to cover the process of credit creation and the effect on economic systems. It might be worth reading alongside Mises' 'Theory of Money...' for an understanding of the business cycle effect on markets.

    Browsing the Mises Institute's literature archives I also found to following category which may be relevant:

    "Financial Cycles, Business Activity, and the Stock Market" by Antony Mueller sounds relevant.