How Ben Bernanke and Paul Krugman Are Destroying the Economy

In 1974, Friedrich Hayek (an Austrian Economist) won the Nobel Prize in economics. The following excerpt is part of his prize lecture. I will be adding commentary to demonstrate why Hayek’s speech from 1974 is still relevant today. In the speech, Hayek points out the problems with mainstream economics (which has changed relatively little since Hayek first gave this speech) and why the Austrian view better explains the actions of the market.

Hayek states:

… the very measures which the dominant "macro-economic" theory has recommended as a remedy for unemployment, namely the increase of aggregate demand, have become a cause of a very extensive misallocation of resources which is likely to make later large-scale unemployment inevitable.

Here, Hayek is describing the current demand-side neo-classical (Keynesian) mainstream theory of economics, which is espoused by people like Paul Krugman and Ben Bernanke. Hayek notes that policies which adhere to such theories create a massive misallocation of resources into unproductive jobs, which inevitably leads to mass layoffs.

The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate - or perhaps even only so long as it continues to accelerate at a given rate.

This is an exact description of the housing bubble. As the Fed drove interest rates down, allowing the GSEs to create extremely low interest rate mortgages, this enticed people to take out excessive home loans. The new money created by the home lending market drew labor and resources into the construction of new homes at a level that was unsustainable. This bubble continued to grow as long as cheap financing was available to the home lending market.

What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained and which after some time can be maintained only by a rate of inflation which would rapidly lead to a disorganisation of all economic activity.

In other words, due to the cheap interest, a bubble was created. After some time, this artificial bubble must pop, leading to mass unemployment as the resources that were directed into housing must now be redirected to different areas of the economy.

The fact is that by a mistaken theoretical view we have been led into a precarious position in which we cannot prevent substantial unemployment from re-appearing; not because, as this view is sometimes misrepresented, this unemployment is deliberately brought about as a means to combat inflation, but because it is now bound to occur as a deeply regrettable but inescapable consequence of the mistaken policies of the past as soon as inflation ceases to accelerate.

Alternatively stated, when the Fed ceases to print money, mass unemployment must result, because the printed money is diverting resources into unproductive tasks. Presently, the Fed has NOT yet ceased printing money. The housing bubble popped due to the banking crisis created by defaulting home loans, but that bad debt was not liquidated as it should have been, instead it was transferred to the tax payer. Now we are in a situation where if the Fed ceases to print money, it will bring about the collapse of the entire banking sector AND the collapse of state financing. 

If you think the high unemployment rates from the bursting of the housing bubble are bad, just wait till you see what happens when the bond bubble implodes and the currency becomes worthless. The Fed can’t keep interest rates at zero forever. When they finally rise, economic chaos will ensue.  Imagine if everyone working in finance and government were laid off tomorrow.

The entire speech can be found here at the Nobel Prize website.