Consulting by RPM || Free Advice Blog

Praising Krugman on His Critique of Fama and Cochrane

In response to a reader request (who is probably now horrified), at the Mises blog I addressed an old Krugman post on what he called the “Dark Age” of macroeconomics. Here’s the news you can use:

Krugman is totally right. (!!) Fama and Cochrane are wrong in spinning out what appear to be tautologies above. And I say this, knowing full well that plenty of free marketeers–myself included–critique deficit-spending using the exact same arguments when writing an op ed or getting interviewed on the radio.

To a first approximation, and especially if you’re dealing with somebody who doesn’t know the first thing about scarcity, then yes I think it’s fine to say, “Every dollar the government spends just means one fewer dollar spent in the private sector.” But that’s actually not correct, at least not in the way most people believe. And it’s also not literally true to say, “If the government creates a job in industry X with a subsidy, then there must be an offsetting job destroyed in industry Y because of higher taxes or interest rates.”

This is actually quite simple: Suppose the government imposes a one-shot head tax on Bill Gates of $1 million, and then uses the revenue to hire 50 people at $20,000 each to work for a year scrubbing graffiti off bridges. Do Austrians really want to say that it’s an accounting necessity that this causes Bill Gates to adjust his behavior such that precisely 50 other people lose their jobs, but only for a year? Of course not–it would be a miracle if exactly that happened because of the new tax on Bill Gates. In fact, no matter how many people are initially laid off because of changes in Gates’ spending and investing, if wages adjust quickly enough, then that excess unemployment can be whittled away.

So does my concession to Krugman mean that he is right to champion government deficits as a way to prop up aggregate demand, to get “money circulating,” to create jobs and start using idle resources?

Of course not. In contrast to the all-clearing-all-the-time view of markets held by Fama and other Chicago School believers in the “efficient markets hypothesis,” Austrians know that it takes time for the market to adjust after the bursting of an unsustainable boom. So yes, during a deep recession, it’s possible for the government to reduce the unemployment rate through various means, especially through printing money. But that doesn’t mean it’s a good thing. The idle period of spare capacity (in both capital and labor) serves a definite purpose in a market economy, and the government sabotages the cleansing process by forcing those resources back to work on any old project that’s “shovel ready.”

I elaborate on this point in some detail here, and Arnold Kling (with a nod to the Austrian School) comes to the same conclusion from a different angle here.

In conclusion, free marketeers shouldn’t focus their efforts on trying to prove that the government is incapable of boosting “total spending.” For one thing, that’s a false proposition, so it’s a bad move to try to prove it. But more important, it concedes that boosting “total spending” is a good thing. No, the important thing is for the economy to steer resources to their most efficient uses. If that process requires, say, prices in general to fall–and hence nominal aggregate expenditures–then who cares? You consume goods and services, not a flow of green pieces of paper.

Now what I didn’t say at the Mises blog–for fear that my posting privileges would be revoked–is that Krugman’s post was actually quite impressive. In other words, not only do I agree with almost everything he said, but I enjoy the way he said it (except for the arrogance). In particular, his analogy with international trade was great, and his chart title (“a case of mistaken identity”) was pretty clever as far as econ jokes go.

*sigh* I don’t think I’m turning into a commie, but I really do understand why leftists think they’re so much more clever than their typical opponents: they are. If you doubt me, let me put it this way: Can you possibly imagine any right-wing production zinging its opponents the way Jon Stewart destroys Fox News in the clip below? Inconceivable.

And note that Krugman’s not picking on some associate econ professor from Bob Jones University. No, he and DeLong tackle big guns, some of whom have Nobel prizes. As readers of this blog know, I think Fama and Friends really have said some pretty ridiculous things lately.