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 on how many often to make a market bust a morality play. Bad things happen to bad people who try and get greedy in financial markets. We party hard during the boom and there is a price that will have to be paid by everyone. We already see this story unfolding in the media.
The consumption portion of the Krugman tale is a little more problematic. Investments creates wealth if the value of the investment goes up. These investments are valued or priced based on their use in the economy. If they are no longer productive, there will be a decline in value associated with this investment which will decrease the wealth of consumers. This wealth effect changes consumption in the bust portion of the cycle. It is not a swtich between consuming or investing.
From Krugman:
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.... The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand... all that investment leads to the creation of too much capacity--of factories that cannot find markets, of office buildings that cannot find tenants... 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.... 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?... 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?
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.... 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. Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives.... But moderates and liberals are not immune to the theory's seductive charms--especially when it gives them a chance to lecture others on their failings...
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