Wednesday, October 22, 2008

Economics: Response to Paul Krugman

I was reading an old article by Paul Krugman (the NYTimes Economist who won the Nobel Prize this year) which was his rebuke to the Austrian Theory on the inevitability of recessions after investment booms. The Article was written in 1998 in response to the Asian Market meltdown, and basically says that commentators who were blaming the freezing of the Asian Market on the Asian bubble bursting in the 1980s are just jumping to false conclusions.

Here's the point on which he faults the necessity of a recession after an investment boom:

"Here's the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?" (emphasis mine).

So my question is, is he correct in his assertion that spending = income? Does his assumption mean that people who take their income from wages and save it in a bank get siphoned back into the investment market?

I think I disagree with his assertion that recessions are absolutely avoidable in the wake of a stock-bubble bursting, but I agree with his criticism of people who use the Austrian Theory to make an argument for the futility of government intervention are also incorrect. I mean, the reason in my mind that a stock-bubble bursting tends to lead to a recession because of the damage in consumer confidence, and the increased need for savings.

I mean, say the investment bubble bursts and loans become harder to secure. People's first impulses will (or ought to be) that they need to save more, because of all the uncertainty they see around them. So, while from a pure economics standpoint, I agree with Krugman that there's no reason why production capacity and consumption capacity would be affected by investments tumbling (although companies that rely on debt spending will be damaged), I don't think I agree with him that the rest of the market can be insulated from an investment collapse; certainly not one on the scale of what we're seeing now.

I mean, I guess I should cut Krugman some slack because he was responding to the Asian market bursting rather than the current financial tsunami, but since he was making a generalized claim, I think it's fair.

I'd also like to point out that Paul Krugman has won a Nobel Prize in Economics. I have read Freakonomics. I do not claim to be any sort of an authority.

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