Another Look at Krugman's 'Hangover Theory'

I'm trying to write something hard, and failing. I'll keep trying. But this is easy, and I cannot resist. Paul Krugman is once again attacking "hangover theorists", the idea that booms of a certain kind inevitably beget recessions.

I do not buy the traditional Austrian story of hangovers — that misallocations and depletions of capital (including human capital) necessarily take time to undo. But I think that now and in his original piece, Krugman is far too quick in his dismissal of the idea that there must be something about some booms that makes subsequent recessions pretty hard to avoid. Krugmans writes that "[a] recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time." It is rather surprising, isn't it, that "whatever reason" almost always happens subsequent to years of unusual prosperity? Choose your poison — if you don't like the Austrians, go with Hyman Minsky — but if we don't acknowledge the relationship between some kinds of booms and the bad times that follow, we'll have a hard time preventing those bad times.

Krugman is absolutely correct to inveigh against the "morality play" that sometimes seeps into the Austrian rhetoric surrounding recessions. Personally, I think morality play deserves a much larger place in economics than it currently has, but a fable in which masses of innocents suffer to absolve the sins of the reckless wealthy is hardly moral. The "hangover theory" is best described as an immorality play, which we are watching unfold before our eyes this very moment as financial assets are relentlessly supported while the value of a pair of hands is let to plummet.

However, recessions and depressions do follow booms, and there are reasons for that. Austrians have their vices, but a vice of Keynesians is to underestimate the role of information. Krugman points out that the hangover theory...

doesn’t explain why there isn’t mass unemployment when bubbles are growing as well as shrinking — why didn’t we need high unemployment elsewhere to get those people into the nail-pounding-in-Nevada business?

The obvious answer is that when there is a boom, entrepreneurs know into what sector resources must be reallocated, and pull already employed workers from existing jobs into the new big thing. During a bust, from a God's eye view, the same process must occur: resources must be shifted out of some sectors and into others. But entrepreneurs are only human. They do not know to where resources might be productively employed, only that they cannot be productively employed where they are. This is the asymmetry, I think, that explains mass unemployment during busts.

Krugman also points out that the hangover theory...

doesn’t explain why recessions reduce unemployment across the board, not just in industries that were bloated by a bubble.

I think that this gets to the point about why it is that only certain kinds of booms lead to great and terrible busts. Industries rise and fall all the time, in good times as well as bad.

In the 1980s, there was a great boom in the recording industry owing to the advent of compact discs. The boom eventually went bust, but mass unemployment did not ensue. Hangovers result not from booms in and of themselves, but from booms which result in unhealthy concentration of the aggregate investment portfolio.

US capital, viewed as a whole, was overly concentrated in housing and construction this decade. China's capital has been overly concentrated in exports and construction. Traditional portfolio theory views the menu of investments as fixed, and suggests that investors diversify among them. But in the aggregate, there is only one portfolio extant at any point in time. The art of "macro portfolio theory" is to control the evolution of that portfolio so that it remains reasonably efficient. The easy answers don't work: Micro portfolio choices don't necessarily compose into a dynamically sane macro portfolio. We have reason to be skeptical of very heavy-handed industrial policy. So we have work to do.

I'll end with an intuition: I think that there's a trade-off between microlevel diversification and macro-efficiency. Barry Bosworth warned that "diversification devalues knowledge". One reason that micro portfolio choices fail to compose is because it is often sensible for investors to "buy the market". Every individual has a unique information set, and ideally we would want all that decentralized knowledge "priced into the market" independently of the judgments of others. However, each individual knows that her own information is profoundly uncertain and incomplete, and that the market represents an aggregation of the judgments of millions of others. So, as passive-investment types have been telling us for more than a decade, it may be optimal for individuals to ignore their own information and defer to the judgement of the market-ex-me. (This is a kind of "information cascade".)

But, each person who defers to the market increases the concentration of investment decision making, and decreases the breath of information that is priced into the market. If the aggregate portfolio is disproportionately based on the decisions of a relatively small group of people, there is no reason to suspect its quality would be better than that decided upon by a bureaucracy of planners. There is reason to suspect, in fact, that it would be worse, because at least the planners know they should at least pretend to serve a broad public interest, while private decisionmakers might quite legitimately think they're just trying to get a piece of next year's bonus pool.

In sum, I think there is a tension between micro diversification and macro diversification. If we want to maintain a well-diversified aggregate portfolio, it may be necessary to restrict the degree to which the portfolio of firms and individuals can be diversified. This implies forcing individuals to bear more risk than they would otherwise choose, in order to reduce systemic risk. We might be better off by letting individuals shed risk via some form of social insurance while forcing investment choices to be sharp, than by encouraging people to blur the information they present in their portfolio choices in order to diversify and hedge.

Comments

[bosun.j:]

The author wrote:

*The obvious answer is that when there is a boom, entrepreneurs know into what sector resources must be reallocated, and pull already employed workers from existing jobs into the new big thing. During a bust, from a God's eye view, the same process must occur: resources must be shifted out of some sectors and into others. But entrepreneurs are only human. They do not know to where resources might be productively employed, only that they cannot be productively employed where they are. This is the asymmetry, I think, that explains mass unemployment during busts.*

Interesting. Entrepreneurs are omniscient - except when they're not.

Entrepreneurs are Gods when picking when to *get in* but only human (lousy) at picking when to get out, and, when to start looking for the next place to *get in*?

Perhaps these *Entrepreneurs* egos and avarice preclude they consider they were lucky.

IMHO, of course.

2008 Dec 30 07:54 AM

[bosun.j:]

The author wrote:

*it may be necessary to restrict the degree to which the portfolio of firms and individuals can be diversified. This implies forcing individuals to bear more risk than they would otherwise choose, in order to reduce systemic risk. We might be better off by letting individuals shed risk via some form of social insurance*

Some form of social insurance? Privatization of profits and socialization of profits? Wait, that's what we have now!

2008 Dec 30 08:08 AM

[bosun.j:]

Oops, sorry! My outrage got the best of me I meant to type socialization of losses. My Bad!

2008 Dec 30 08:10 AM

[TCK:]

As usual, Krugman starts with his political views and then forms his economic thoughts. In his commentary he manages to make points against conservatives and for rasing taxes, even in a recession. Seems like this just another example of a poltical editorial disguised as economic commentary.

2008 Dec 30 08:32 AM

[Chris Butler_:]

I'm sorry, but I don't know what Austrian "morality play" the author is referring to (originally from Krugman, I suppose).

Perhaps the author is referring to the fact that Austrians take issue with the "morality" of inflating the money supply and the following price inflation hits some after the benefits of the increase in money supply are accrued to others. That's about the only "morality play" I can come up with in the Austrian analysis.

Some will say that Krugman is now more an op-ed writer than economicst. A mere mouthpiece for the left-wing straining hard to justify his politics with weak economic theory. I argue that's what he's always been. The only people "hung over" here is the Nobel committee that awarded him his prize.

2008 Dec 30 08:52 AM

[susan kuhn ...:]

Entrepreneurs aren't omniscient, which implies a superior point of view that grants special knowledge. Quite the contrary: What entrepreneurs have is local knowledge. They understand their industry and customer base and the skills to recognize and evaluate opportunities. It's training, experience, mindset, and hard work that goes into creating business growth and jobs in a recession. Recessions are also great times to "work the kinks out" of a new business in time to be in position to grow when the economy improves. I've done it (1990) and am working on starting another business right now that I see a need for as a result of the recession. My approach to starting up is different/slower now because this recession is playing out differently than the previous one. But because of my hands-on experience (not some superior knowledge) I have confidence in my analysis and judgment.

To Krugman's point, it's one thing to move existing employees into new areas (or expand employment) during a boom, and quite another to start up an entirely new business during a recession. Until an entrepreneur establishes a stable business model and revenue stream she won't be adding employees, esp. when financing is so tight.

I am a strong proponent of self employment, as a main or supplemental source of income, during a recession. Such income does not show up in employment figures, so it is not counted in Krugman's analysis. Yet I suspect that many of the "missing employees" he puzzles over may be self-employed. Data on this point would be interesting.

2008 Dec 30 09:33 AM

[D. McHattie:]

"it may be necessary to restrict the degree to which the portfolio of firms and individuals can be diversified. This implies forcing individuals to bear more risk than they would otherwise choose, in order to reduce systemic risk."

Sort of like a ship with a compartmentalized hull so that if the hull is punctured the entire ship doesn't fill with water - only that portion that receives the puncture.

The economy is naturally compartmentalized. The problem is that we had a federal reserve, congress and 16 years of federal governments whose technological ignorance/arrogance, political opportunism and blindness caused them to steer the ship at full-steam straight into waters infested with icebergs.

And the band (CNBC) played on.

2008 Dec 30 10:56 AM

[John Lounsbury:]

Steve - - -

Your article is very thought provoking.

Thought 1. Concentration of wealth has a "freezing out" effect on economic activity. We have gone through a decade of concentration of wealth in a pyramid of financial paper. (I use the term "wealth" loosely, because the concentration was debt created money.) Eventually (2008) this froze every other credit need and burst (among other things) the housing bubble and the attempt of the (formerly) Big Three auto makers to transition to a new business plan. Some may argue that both of the situations needed to be burst, but I would counter that maybe they could have deflated and transformed less violently if the paper pyramid had not been consuming so much resource. This idea is very compatible with the Austrian theories, but I don't believe it has been expressed this way by those proponents. Disclaimer: I have not read everything Austrian. Perhaps another commenter can provide better insight.

Thought 2. You did not mention the Efficient Market Hypothesis and its algorithm: The average investor can not beat the market. However, you did talk all the way around it. Obviuosly, if you select any individual investor at random, there is equal probability that the individual will out perform or under perform the market. Extend to 100 random selections and the most probable result would be a 50:50 split of over:under performers. The algorithm has been misused to consider it as advice to individual investors. It is misused because the probability that any individual investor is "the average investor" is infinitesimal, maybe one out of 100 million. Those are the odds that the person addressed is the one average investor out of 100 million. The author has taken these ideas further and what he says relates to my first thought. If too much concentration of financial wealth creates economic problems (my thought), too much concentration of intellectual wealth can also create problems (Steve Walden's thought). Concentration of financial wealth freezes out credit (my thought 1.). Concentration in index investing freezes out intellectual wealth and, therefore, weakens the index (Steve Walden's thought).

All this brings me to a greater appreciation of the comment by susan kuhn frost. Too much concentration of wealth freezes out of the market place the "local knowledge" of entrepreneurs. Index investing does the same thing.

I expect there may be others who can relate to or contest some of these thoughts. Please take the time to place a comment and add to this as you see fit.

Steve, every time I read one of your articles I am reminded why I put you on my watch list to begin with.

2008 Dec 30 01:20 PM

[sr9web:]

Recesssions are caused by two things:

1) Business and personal income streams are interdependent and once any of them start to contract (which they do periodically as buying appetites get sated - such as what just happened in real estate), then various connected streams of income are affected.

2) People, whether in business or personal, when they see their streams of income contract, get fearful and cut spending. This compounds the contraction.

Recessions end when people feel that they are no longer at imminent risk.

The foundations for recessions start when speculators pour too much borrowed money into any particular market. Eventually, as what just happened in real estate, that market reaches its saturation point and some of the money must bleed off.

2008 Dec 30 01:36 PM

[Sol Rosenberg:]

It's hard to take any critique of ABCT seriously when the critique doesn't even mention central banking. Nary a word about the Fed in this post or Krugman's post. The effect of central banking is the cornerstone of ABCT, not "hangovers" or "morality plays".

BTW, for an easy to understand explanation of Keynesianism, turn to none other than Fred Thompson:
www.youtube.com/watch?...
Too bad he was never this lucid during his campaign.

2008 Dec 30 11:21 PM