Robert Murphy on the Austrian School and Keynesianism

So I've been meaning to write about this new post by Robert Murphy that "puts the Austrian business cycle theory to the test". I wanted to share a few thoughts and get people's reactions.

The post is a decent catalog of some of the problems with Krugman's take on things, a good start for explaining the congruence of the crisis with ABCT, but a very bad attempt to draw conclusions from that.

1. First, Murphy is right to point out indices of decline rather than absolute declines (which Krugman does). Construction has seen a higher rate of job loss than manufacturing, which is of courses consistent with ABCT.

2. Murphy notes that Austrians opposed a suite of government actions. He writes: "Now say what he will about the Austrian economists, surely Dr. Krugman will concede that they opposed the above actions, and that they would have predicted at any time that these policies would lead to economic stagnation". It's true that they opposed these actions, but then again Krugman said many were inadequate or just plain wrong too. It's worth probing what each side predicted the effect would be. Krugman (and I for that matter) suggested we would have continued deflation and low interest rates. Not all, but a sizable portion of Austrians predicted inflation and high interest rates. This makes sense - both of those results are easily derived from Keynesian and Austrian approaches, respectively. So Krugman and the Austrians were both right here - but who was right for the right reasons? Generally speaking, I'd say Krugman.

3. Robert Murphy is being entirely disingenuous when he writes this: "In contrast to the Austrian story, what does the Keynesian view predict? Well, if a recession is really just about a general drop in aggregate demand, then we shouldn't see any particular relationship among individual sectors, and how they respond both in magnitude and across time. If you reread Krugman's commentary on his chart, that's exactly what he himself says the Keynesian story means." What can spark a demand shock? Lots of things, of course - but one major cause is a popped bubble that leaves people with a lot less income and wealth than they previously had. Murphy abstracts away from the bubble completely and acts like this is all a question of the capital structure and roundaboutness. You can't remove the housing crash from this narrative - that was the aggregate demand shock which brought the rest of the economy down. The question shouldn't be "how do Keynesians account for the construction employment" - that's obvious - there was a housing crash after some standard bubble psychology and bad policy. The question should be "how do Austrians account for the breadth of unemployment". Clearly the basic rebalancing of the capital structure can't explain this. You need some story about malinvestments as overinvestments or overproduction in addition to the standard malinvestment story. The case can be made, but the onus doesn't seem to be on the Keynesians.

4. So where do we end up with Murphy? Well he's using the same fallacious logic that I had to correct from him with my 1920-21 depression paper. Is this downturn consistent in some important respects with ABCT? Sure. Of course it is. My feeling is that that is because ABCT is a logical and accurate theory of a real macroeconomic process. So of course you're going to see it in the real world. Does that mean the Keynesian explanation is wrong or not also consistent? Of course it doesn't. These are not mutually exclusive processes that we're describing here, and the theories that you're promoting are only mutually exclusive because you have defined them as such. You don't just assume that oil embargoes can't cause recessions because you've attached the "Keynesian" or "Austrian" label to your lapel, do you? No - because the supply shock of an oil embargo isn't inconsistent with additional demand shocks or capital structure adjustments. Robert Murphy lives in a Manichean world, not a scientific world. He wants economic theories to engage in a battle of the titans. This was how it was with his explanation of the 1920-21 downturn too. For Murphy, if ABCT fit the facts (he didn't make that much of a case that it did - he barely talked at all about the capital structure), then Keynesianism couldn't fit the facts. Part of this was simply because he grossly misunderstood Keynesianism, but a lot was also because he couldn't accept the fact that under some circumstances Keynesianism and ABCT predict much the same thing.

So long story short, I think Murphy makes some decent points and a good beginning of a case for ABCT, but draws some very bad conclusions from it.