Krugman Flunks Capital Theory

Paul Krugman is said to have beat up on George Will during this joint appearance on ABC's "This Week" back in November. But all Krugman really did was show that he, like Keynes, holds an unrealistic Play-Doh model of capital, as opposed to the heterogeneous, multistage, intertemporal structure-of-production model of the Austrian school. When Will notes that there was negative net investment during the 1930s, Krugman responds that, of course, there was negative net investment: "Because when . . . all the factories are standing idle, who wants to build a new one?"

Point for Krugman? Wrong.

If Krugman took the Mises-Hayek trade cycle theory seriously he'd realize that the idle factories in the 1930s represented malinvestment induced by Federal Reserve credit expansion in the 1920s. This policy, by lowering the interest rate and falsely signaling an increase in real saving (i.e., a preference for future over present goods), shifted resources from later stages of production (closer to the consumer) to earlier stages of production. Unfortunately, those who think of capital as a heap of homogeneous, monochrome Play-Doh aren't sensitive to this point. Capital is capital is capital. That's why Krugman can't understand why someone would want to invest when factories stand idle.

When the inflationary boom ended, as it had to because it was artificially induced and there weren't enough resources for both the early stages and the later stages (where consumers wanted them), the malinvestments had to be liquidated. But since capital consists not of Play-Doh but of discrete things -- buildings, machinery, tools materials -- with particular characteristics, those that were the products of malivestment were not necessarily suitable for other purposes. They couldn't simply, costlessly, and instantly be moved and employed in later stages of production. Hence, the idle factories. This was wasted capital brought about by the credit expansion. This was the depression.

If the economy was to recover, new investment consistent with consumers' actual preferences had to be undertaken. But that required time and saving, i.e., deferred consumption. It also required a stable political environment in which investors could be confident that their property was safe from the government. Unfortunately, thanks to tax increases, unending interventionist programs, and threatening antibusiness rhetoric, FDR's government failed to provide that environment.

Krugman's flip remark to Will is a perfect illustration of what is wrong with Keynesian economics.

Cross-posted at Anything Peaceful.