Disciplined Systematic Global Macro Views

An interesting discussion on Brad Delong’s blog posted a comment on the hangover theory of financial crises by Paul Krugman. Worth a look. It makes a good comment about how many to make a market bust a morality play often. Bad things happen to bad people who try to get greedy in financial markets. We party hard through the boom and there is a price that will have to be paid by everyone. We already see this story unfolding in the press. The consumption portion of the Krugman tale is a bit more problematic. Investments creates wealth if the worthiness of the investment goes up. These investments are valued or costed based on their use throughout the market.

If they are no longer productive, you will see a drop in the value associated with this investment that may decrease the wealth of consumers. This prosperity effect changes in consumption in the bust portion of the cycle. It isn’t a switch between trading or consuming. The hangover theory is seductive–not because it offers a simple way out perversely, but because it doesn’t.

It transforms the wiggles on our charts into a morality play, a tale of the downfall and hubris. The total result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is area of the necessary healing up process: The excess capacity gets worked off, prices and wages fall using their excessive boom levels, and only then is the economy prepared to recover. But let’s ask a seemingly silly question: Why if the ups and downs of investment demand lead to fluctuations in the economy all together?

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Here’s the problem: As being a matter of simple arithmetic, total spending throughout the market is necessarily add up 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 invest more on usage goods–implying an investment slump should always be accompanied by a corresponding consumption boom?

And if so why should there be a rise in unemployment? Most modern hangover theorists probably don’t even realize this is a problem for their story. Nor do those supposedly deep Austrian theorists answer the riddle. The best that von Hayek or Schumpeter could come up with was the vague suggestion that unemployment was a frictional problem created as the economy transferred employees from a bloated investment goods sector back again to the production of consumer goods. The hangover theory, then, actually is intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good employees in today’s. The theory has powerful emotional charm.

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