Lesson 7 of 8
The hangover argument
Krugman's objection is an accounting one: if investment spending falls, consumption should rise, so why does a slump hit every industry at once.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The objection: total spending equals total income, so a fall in investment demand should be matched by a rise in consumption, not by everyone being idle.
- Krugman's own account is that a slump is an excess demand for money, and that if so, the bad investments of the past do not require good capacity to sit unused now.
- The replies that engage it hold that the theory is about the boom rather than the depth of the slump, and that the tradition explains unemployment much as other schools do.
Krugman's piece appeared in Slate in December 1998. It is journalism rather than a paper, it is openly dismissive in tone, and it contains one objection that is worth more than its tone suggests.
The step the objection says is missing
What the accounts agree on
- An investment boom can create capacity that turns out to be unwanted.
- The disappointment arrives suddenly and investment spending collapses.
- Some workers have to move between sectors.
- Moving takes time and is costly.
What the objection asks for
- Why does consumption not rise as investment falls.
- Why do industries outside the investment sector contract too.
- Why is the same argument not made about the boom, which also reallocates.
- What mechanism turns a reallocation into idleness.
A theory of misdirected investment is not yet a theory of general unemployment.
The argument, as he makes it
He groups several theories together as the hangover theory: the view that slumps are the price paid for booms, and that the suffering is a necessary correction of previous excess.
His objection runs through the accounting identity. Total spending in an economy equals total income, because every sale is a purchase. If people decide to spend less on investment goods, that appears to imply they are deciding to spend more on consumption, in which case an investment slump should come with a consumption boom and no general rise in unemployment. He grants that the story about overbuilding describes investment cycles well and denies it explains the economy-wide part.
His own answer is that a recession happens when a large part of the private sector tries to hold more money at once, and that if the problem is an excess demand for money then the remedy is more money. On that view the bad investments should be written off and the bad loans junked, and none of that requires productive capacity to be left idle.
He also makes an argument about the appeal of the theory rather than its content: that it turns the cycle into a morality play, and that its moral attraction explains its persistence better than its explanatory power does. That part is rhetoric, and it is reported here because leaving it out would make the piece look more clinical than it is.
The replies that engage the objection
Garrison's answer, published a decade earlier, is that the theory is not primarily a theory of depressions at all. It is an account of an artificial boom and of the process that ends it; how deep and long the resulting unemployment is depends on wages, prices and policy, and on those questions the tradition's answers resemble other schools' rather than being peculiar to it.
Salerno's answer is the complementarity mechanism from the previous lesson: labour and other convertible inputs are drawn back toward the later stages, bidding up their cost, and higher-stage projects are abandoned even when finished, which is a general dislocation and not a tidy swap of workers between two sectors.
Neither reply meets Krugman's monetary point head on. If an economy is short of money relative to the demand to hold it, the tradition's own monetary theorists have things to say about that, and this course has not found a published reply that puts the two arguments together in one place.
What to take from it
The objection is a demand for a mechanism, and the demand is reasonable. A theory that explains why the wrong things were built has not yet explained why the right things stop being made.
That is worth holding when you read the rest of the track. The account of the boom and the account of the depth of the bust are separable, and a reader can accept the first without the second.
Check yourself
What is the accounting core of the objection?
- That investment is measured badly
- That total spending equals total income, so falling investment demand should imply rising consumption rather than general idleness
- That interest rates cannot fall below zero
Show the answer
Answer: B.
Krugman's piece builds the objection from the identity and asks why a decline in investment demand makes the whole economy slump.What does Krugman say a recession actually is?
- A necessary correction of past excess
- A situation in which much of the private sector tries to increase its money holdings at once
- A fall in productivity growth
Show the answer
Answer: B.
That is his stated alternative, and the remedy he draws from it is to increase the supply of money rather than to let capacity stand idle.What does Garrison's reply concede?
- That credit expansion does not distort the structure of production
- That the depth and length of the resulting unemployment is handled much as other schools handle it
- That the theory only applies to small economies
Show the answer
Answer: B.
His article says the theory is about the artificial boom and the process that ends it, and that the unemployment question is dealt with in ways similar to several other schools.Sources
- Krugman, 'The Hangover Theory', Slate, December 1998: the grouping of overinvestment accounts as the hangover theory, the accounting objection built on spending equalling income, the claim that a slump is an excess demand for money, and the argument about the moral appeal of the theory.
- Garrison, 'The Austrian Theory of the Business Cycle in the Light of Modern Macroeconomics', Review of Austrian Economics, volume three, opening section: the statement that the theory is about artificial booms and the process that ends them, and that the depth of the ensuing depression is treated in ways similar to several other schools.
- Salerno, 'Comment on Tullock's Why Austrians Are Wrong About Depressions', Review of Austrian Economics, volume three: the complementarity mechanism offered as the answer to the same unemployment question.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- Krugman's piece is a magazine column, not a peer-reviewed paper, and it is reported as such. Its objection is treated here on its merits rather than on its venue.
- This course found no published reply that answers the monetary half of the objection directly. That gap is stated rather than filled.