From exchanging emails with him, I've known for a decade that Paul Krugman was an egomaniacal jerk, but he was always described as being intelligent. Yet, here are parts of a 1998 column he wrote in Slate that is just jaw-droppingly dumb. This is the kind of thinking that kept us from having the medium strong recession we deserved in 2001 after the Tech Bubble, instead, postponing it until a recession/depression of Biblical proportions arrives now.

While you are reading Krugman's theorizing denouncing the the Austrian business cycle theory that malinvestment causes recessions, think about Las Vegas.

Sin City had the biggest boom of the decade and now the biggest bust with, by far, the highest foreclosure rates. Why? Because it's next to California. The median homeowner in California saw his home equity rising by, say, $60,000 per year in the middle of the decade. A lot of those Californians took out home equity loans, gassed up their new cars, and headed to Vegas to spend some of that $60,000 in additional wealth. (My barber used to go five or ten times per year to Vegas.)

So, businesses built more gigantic casinos in Las Vegas, which employed lots of construction workers and then service workers to work inside the casinos. In turn, they built tons of homes outside Vegas for, depending on the price range, all the new construction and service workers, or all the people trying to get away from living next to the new construction and service workers. Meanwhile, the price of existing homes was going through the roof in Las Vegas, so the local homeowners were all spending money like they were Californians, too. And, in turn, they built tons of retail and other stuff, like, say, water parks, to service all those new residents and their kids.

All of sudden, people in California wake up to the fact that they aren't as rich as they thought they were. In fact, they are much poorer because they've already spent much of the pseudo-wealth they thought they had garnered in the middle of the decade. They can't cash out on their houses, so they are suddenly looking at 28 years of writing big monthly checks to pay for all those trips to Las Vegas.

What's the first thing you can cut out of the household budget? Well, the single most obvious luxury to eliminate is those goddam trips to Las Vegas.

Thus, news stories like this one from today on Channel 8 in Las Vegas:

Wall Street Crushing Las Vegas Strip

There are more signs of just how much the Las Vegas Strip is hurting in this economic downturn. One of the valley's biggest casino companies, Boyd Gaming, saw a huge drop in profits, down 73-percent in the third quarter.

The company has also announced the delay of its signature resort, Echelon, will be much longer than anyone expected. The construction site will sit quiet until at least January of 2010.

The jobs are gone and the equipment will be parked longer than first thought.

After the Stardust saw its last roll of the dice in a spectacular demolition, from the ashes would rise Echelon, a multibillion dollar mega resort. But for now, all bets are off.

"It is unlikely that we will resume construction in 2009. Nonetheless, we remain committed to having a meaningful presence on the Las Vegas Strip," said Boyd Gaming President and CEO Keith Smith. Boyd Gaming announced in its third quarter earnings conference call. Echelon will remain a shell of steel through 2009. Construction will be halted while executives consider a list of options.

Here's what the $4.75 billion Echelon project looked like when work was suspended last August.

Think about things from Boyd Gaming's point of view: So, you bought the Stardust, a tired but no doubt still profitable casino, blew it up, and poured vast amounts of money into building a superstructure for the multibillion dollar Echelon. Except now, there are no more gamblers coming from California. So, it won't pay to finish it for years. Except, while it's sitting unfinished, you are still losing all the cost of capital you've invested in it so far.

Keep that in mind while you are reading the new Nobel Laureate's explanation of why the Austrian theory is all wrong (via Zoho).

The Hangover Theory Are recessions the inevitable payback for good times? By Paul Krugman Posted Friday, Dec. 4, 1998, at 3:30 AM ET

A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the "Austrian theory" of the business cycle–a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire. Oh well. But the incident set me thinking–not so much about that particular theory as about the general worldview behind it. Call it the overinvestment theory of recessions, or "liquidationism," or just call it the "hangover theory." It is the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion.

The hangover theory is perversely seductive–not because it offers an easy way out, but because it doesn't. It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love.

Powerful as these seductions may be, they must be resisted–for the hangover theory is disastrously wrongheaded. Recessions are not necessary consequences of booms. They can and should be fought, not with austerity but with liberality–with policies that encourage people to spend more, not less. Nor is this merely an academic argument: The hangover theory can do real harm. Liquidationist views played an important role in the spread of the Great Depression–with Austrian theorists such as Friedrich von Hayek and Joseph Schumpeter strenuously arguing, in the very depths of that depression, against any attempt to restore "sham" prosperity by expanding credit and the money supply. And these same views are doing their bit to inhibit recovery in the world's depressed economies at this very moment.

The problem in the Great Depression was the sharp contraction of the money supply due to bank runs, which is why we now have FDIC insurance.

The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand. Maybe excessive money creation or reckless bank lending drives it, maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. Whatever the reason, all that investment leads to the creation of too much capacity–of factories that cannot find markets, of office buildings that cannot find tenants. Since construction projects take time to complete, however, the boom can proceed for a while before its unsoundness becomes apparent. Eventually, however, reality strikes–investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover.

Except for that last bit about the virtues of recessions, this is not a bad story about investment cycles. Anyone who has watched the ups and downs of, say, Boston's real estate market over the past 20 years can tell you that episodes in which overoptimism and overbuilding are followed by a bleary-eyed morning after are very much a part of real life. But let's ask a seemingly silly question: Why should the ups and downs of investment demand lead to ups and downs in the economy as a whole? Don't say that it's obvious–although investment cycles clearly are associated with economywide recessions and recoveries in practice, a theory is supposed to explain observed correlations, not just assume them. And in fact the key to the Keynesian revolution in economic thought–a revolution that made hangover theory in general and Austrian theory in particular as obsolete as epicycles–was John Maynard Keynes' realization that the crucial question was not why investment demand sometimes declines, but why such declines cause the whole economy to slump.

Here's the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal 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 spend more on consumption goods–implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?

Krugman is so proud of his little abstract tautology.

No, what's happening now is fundamentally driven by a wealth effect. Yes, we currently have a liquidity crisis and an insolvency crisis. The government throwing money at the liquidity crisis might well help, and there's some possibility of it helping the insolvency crisis.

But there's no way no how the government wasting money will help the fundamental problem: the wealth crisis. That's only going to be dealt with by years of hard work.

People now realize they aren't as wealthy as they thought they were. Something like one-tenth of the national wealth was made up of ridiculous valuations of homes. That's gone. It ain't coming back for decades. Another, harder to estimate, fraction of the national wealth was made up of ridiculous valuations of financial instruments based on the ridiculous valuations of the homes. That's gone, too.

They are gone because they never really existed in the first place. They were just mass delusions that 500 sq. ft. homes in Compton were worth $340,000, or that complicated mortgage-backed securities and credit derivatives based on the expectation that the guy who got the $340,000 mortgage on that one-bedroom house in Compton was pretty damn likely to pay it all off, were worth what Moody's said they were worth.

Both consumption and investment spending up through the first half of 2007 were driven by estimates of how much we could afford based on our wealth that we now know were ludicrous. Economic activity will therefore contract to the level appropriate for our smaller level of wealth.

Most modern hangover theorists probably don't even realize this is a problem for their story. Nor did 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 workers from a bloated investment goods sector back to the production of consumer goods. (Hence their opposition to any attempt to increase demand: This would leave "part of the work of depression undone," since mass unemployment was part of the process of "adapting the structure of production.") But in that case, why doesn't the investment boom–which presumably requires a transfer of workers in the opposite direction–also generate mass unemployment? And anyway, this story bears little resemblance to what actually happens in a recession, when every industry–not just the investment sector–normally contracts.

As is so often the case in economics (or for that matter in any intellectual endeavor), the explanation of how recessions can happen, though arrived at only after an epic intellectual journey, turns out to be extremely simple. A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time. Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it's not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?

I'm surprised Krugman didn't also win the Nobel in Medicine, because his advice is equally applicable to physiology:

A death happens when, for whatever reason, a the heart stops beating. Yet, for all its simplicity, the insight that a death is about a heart no longer beating makes nonsense of the whole disease / trauma theory. For if the problem is that the heart isn't beating, why not simply increase the supply of heartbeats? You may tell me that it's not that simple, that the patient has died of bubonic plague or from falling off a cliff. Well, fine. Junk the bad heart and write off the bad organs. Why should this require that perfectly good productive capacity be left idle?

Look, the hulk of the Echelon on the Strip isn't perfectly good productive capacity. It is, at present, perfectly no good productive capacity. It's worse than nothing because the owner has to keep paying the interest on the loans he took out for the money he's already spent on it. He has calculated, however, that it's somewhat less ruinous to let it sit idle than to finish the monstrosity for the Californians who won't be coming again for years. So, the owner of the Echelon isn't going to be spending as much on either consumption or investment as he had been planning to.

The hangover theory, then, turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present.

But the newly unemployed of Las Vegas aren't good workers in the post-Bubble economy. They are construction workers, croupiers, waiters, touts, whores, and other professions that we won't have much use for for a number of years. Hopefully, some of them will develop new, more valuable skills, but that will take years. And when you actually check the numbers on the newcomers to Las Vegas, you don't get a warm feeling that many of these folks are going to turn into solar energy technology inventors or whatever anytime soon. If we're lucky, a lot of them will go home to Mexico, where it's much cheaper to be poor than in America. If we're not lucky ...

Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives, who can't stand the thought that positive action by governments (let alone–horrors!–printing money) can ever be a good idea. Some libertarians extol the Austrian theory, not because they have really thought that theory through, but because they feel the need for some prestigious alternative to the perceived statist implications of Keynesianism. And some people probably are attracted to Austrianism because they imagine that it devalues the intellectual pretensions of economics professors.

Well, we can't have that!

Unfortunately, due to advice like Krugman's, we didn't have much of a recession in 2001-2002 due to inflating the money supply, both by the Fed and by easing up on mortgage lending rules, so now we are paying the price in spades.

The Tech Bubble was stupid, but at least pouring huge amounts of money into Cisco Systems had a certain surface plausibility. Cisco actually made something (either switches or routers, I can't remember which, despite reading dozens of articles in 1996-2000 but how the world could never get enough switches and/or routers). In contrast, building oversized homes outside of Las Vegas for the mortgage brokers who sold their old homes to the new blackjack dealers who got hired by the new casinos to fleece the Californians with home equity loans on their houses that were going to rise in price to infinity never ever made any sense.

Now, anti-Krugmaniac realist economics has a very valuable policy implication, which is: "frictional problems" are incredibly painful. So, don't waste money in the first place. More specifically, the spending of a population is based on its wealth. In the long run, its wealth is mostly a function of its human capital (i.e., the population's ability to earn money). So, don't debauch the average human capital of your population.