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June 02, 2005

Paul Krugman Gets in Touch with His Inner Friedrich Hayek

Not Hayek the post-WWII libertarian political philosopher, but Hayek the interwar business cycle theorist.

Hayek's theory of depressions was that they started when, for some reason, interest rates got too low--below fundamentals. If interest rates are low, asset prices are high--above their fundamentals. Because financial markets are sending false signals that capital--whether in the form of machines, business organizations, commercial buildings, or housing--is very valuable, the market shift resources into capital-producing sectors and adds to its capital stock.

Someday, however, interest rates return to their fundamentals. When they do, asset prices fall sharply: it becomes clear that there are a lot of business organizations, machines, commercial structures, and houses that do not produce value to cover their costs. The last thing needed is more investment. Workers, entrepreneurial energy, and capital have to be shifted out of capital-goods production and into the production of consumer goods and services. And, said Hayek, it is that painful, lengthy, but necessary process of shifting resources out of capital-goods production that we call a "depression."

In Hayek's monetary overinvestment theory of the business cycle, the magnitude of the depression depended on the magnitude of the required structural shift, which depended on (a) how much interest rates had been pushed below fundamentals, (b) how long they had been pushed there, and (c) how much damage--in terms of capital investments that should not have been made given fundamental values--the false prices fed to the real economy by the financial sector had done.

It was a corollary to Hayek's main theory that lowering interest rates when a boom was ending was a counterproductive thing to do. It would push off the depression, yes. But only at the price of magnifying the overinvestment imbalance and thus magnifying the magnitude of the depression when it finally arrived.

It was bad luck for Hayek that he proposed his theory just as the Great Depression arrived. It was not a plausible theory of the Great Depression, not a plausible theory at all.

But today we see Arch-Keynesian Magister Paul Krugman flirting with a Hayekian line wobble:

Running Out of Bubbles - New York Times: Remember the stock market bubble?... [A] few pessimists, notably Stephen Roach of Morgan Stanley, argue that we have not yet paid the price for our past excesses. I've never fully accepted that view. But looking at the housing market, I'm starting to reconsider.

In July 2001, Paul McCulley, an economist at Pimco, the giant bond fund, predicted that the Federal Reserve would simply replace one bubble with another. 'There is room,' he wrote, 'for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism.... [I]nterest rate cuts led to soaring home prices, which led in turn not just to a construction boom but to high consumer spending, because homeowners used mortgage refinancing to go deeper into debt. All of this created jobs to make up for those lost when the stock bubble burst.

Now the question is what can replace the housing bubble.

Nobody thought the economy could rely forever on home buying and refinancing. But the...[I]f the hectic pace of home construction were to cool, and consumers were to stop borrowing against their houses, the economy would slow down sharply. If housing prices actually started falling, we'd be looking at a very nasty scene.... That's why it's so ominous to see signs that America's housing market... is approaching the final, feverish stages of a speculative bubble.... In parts of the country there's a speculative fever among people who shouldn't be speculators that seems all too familiar from past bubbles - the shoeshine boys with stock tips in the 1920's, the beer-and-pizza joints showing CNBC, not ESPN, on their TV sets in the 1990's....

[I]t's true that the craziest scenes are concentrated in a few regions, like coastal Florida and California. But these aren't tiny regions; they're big and wealthy, so that the national housing market as a whole looks pretty bubbly. Many home purchases are speculative; the National Association of Realtors estimates that 23 percent of the homes sold last year were bought for investment, not to live in. More than 30 percent of new mortgages are interest only, a sign that people are stretching to their financial limits.

The important point to remember is that the bursting of the stock market bubble hurt lots of people - not just those who bought stocks near their peak. By the summer of 2003, private-sector employment was three million below its 2001 peak. And the job losses would have been much worse if the stock bubble hadn't been quickly replaced with a housing bubble. So what happens if the housing bubble bursts?...

Mr. Roach believes that the Fed's apparent success after 2001 was an illusion, that it simply piled up trouble for the future. I hope he's wrong. But the Fed does seem to be running out of bubbles.

I would admonish him for this wobble away from Keynesian orthodoxy toward Stephen Roach-Friedrich Hayek deviationism. But I feel the same way. With each month that passes Roach and Hayek look a little bit better.

Posted by DeLong at June 2, 2005 10:51 AM