Unfortunately it was not forgotten, and the mercantilist thinking on growth and output that dominates his economics is the fundamental reason why the world is going through another severe financial crisis. According to him implicit government guarantees to financial intermediaries were largely the cause of the Asian crisis. I think it's fair to say that this is the heart of Krugman's analysis with respect to the present situation.

There is no doubt in his mind that these guarantees are the real villain of the piece. Of course, these guarantees would have contributed to the distortion of investment decisions by encouraging speculation in risky ventures which in turn led to "overinvestment". Krugman has given examples of how this process would work in practice. What finally caused the bubble to burst was the realisation that the guarantees could not be fulfilled.

herefore when the crisis strikes the appropriate policy would be "an injection of capital, which can’t reverse the original shock, but can undo the financial multiplier effect of that shock". (The International Finance Multiplier). And this is his economic prescription for the present crisis.

There are several striking things about Krugman's approach: first, he makes no reference to real factors. Second, capital as the material means of production does not rate a mention. Third, the role of credit expansion is dismissed. Fourth, makes no reference to the degree to which government intervention can greatly worsen a crisis. (When writing on the Asian crisis he made no mention of how government planning, especially in South Korea, made things much worse). Fifth, for him there is no capital structure. Sixth, even the structure of relative prices does not warrant any consideration.

Any economist will tell you that subsidising a product will tend to increase its output. It is much the same with financial guarantees. When governments make such guarantees they are in fact encouraging reckless behavior, which is bad enough. On the other hand, there is absolutely no way that such guarantees can lead to general "overinvestment", as Krugman asserts.

In reality, no more can be invested than is saved. Krugman admits this for a closed economy but not for one that can borrow abroad. But this fact still holds even if it is only foreign savings that are invested. It really does not matter. What Krugman was struggling with is the phenomenon of the sudden appearance of a concentrated mass of malinvestments. (The same thing is happening today). This phenomenon is as old as industrial society and one which classical economists discussed at length.

Let us look at Krugman's central thesis. If a government guarantees cheap loans to certain producers they will then expand their operations beyond the point justified by market data. No informed person would dispute this. But to suggest that these guarantees could lead to most companies over investing once they had access to foreign savings beggars belief.

Even if foreigners accepted the guarantees this would mean having to annually import masses of capital goods with very little return to the foreign investors. The alternative would be to convert foreign savings into the domestic currency and then use it to impose forced savings on the populace. Whichever way we look at it, the government-guarantee approach does not add up. It simple cannot explain the size and nature of the enormous clusters of business failures that Asia suffered.

First and foremost, the general idea of overinvestment is a fallacy. What is not a fallacy is relative overinvestment. And that is what government guarantees do. They cause certain firms or stages of production to over invest relative to other stages of production or firms. That is to say, government guaranteed investments can only take place at the expense of investment elsewhere.

However, when governments force down the rate of interest by expanding credit ("turning stone into bread" as Keynes once enthusiastically put it) they make certain operations, especially in the higher stages of production, more profitable. This is where most of the excessive investment will occur. A moment's reflection makes it clear that expanding credit by forcing interest rates down misdirects production by changing relative prices, i.e., it creates what the Austrians call malinvestments. The greater the expansion, the more malinvestments. It is this process that accounts for the drop in production that occurs in the final phase of the boom.

Even if the government delays in taking action to curb the speculation that credit expansion inevitably fuels, countervailing forces will be been set in motion by the expansion. These self-correcting forces will burst the speculative bubble even if the government does not tighten the monetary screws and still tries to maintain its guarantees. Much was made of the price boom in Asian assets. But why should anyone have been surprised? Many of these assets are titles to capital goods and land. While the boom is progressing returns to land and capital rise — any wonder, then, that titles to them also rose.

Of course, as the boom continues to progress all caution is abandoned and a herd instinct tends to take over, optimism becomes irrational and asset prices are inflated far beyond any conceivably justifiable market price, as happened in the US. That booming asset prices preceded the present financial crisis should come as no surprise to informed commentators, of which there are only a few.

Planning and corruption did not cause the Asian crisis anymore than Fanny Mae and Freddie Mac caused the current one but they certainly aggravated it by adding to the malinvestments. Krugman error is that he cannot differentiate between effect and cause. And the root cause of financial crises is always credit expansion. I do not know of a single boom followed by a financial crisis that was not preceded by credit expansion.

Krugman admits that his forecasting record is not what one might call brilliant. In fact, if he had worked for a stock broker he would have been fired. My point is that accepting as accurate economic predictions from economists who ignore both monetary and real factors is akin to playing Russian roulette with 5 rounds in the chamber.

There is nothing new in the foregoing explanation. The analysis is pure Austrian, even though its roots go back to Ricardo and the insights of the currency school. Instead of looking where he went wrong in his economics, Paul Krugman spends his time at the New York Times spewing anti-Republican lies, bile and hatred while simultaneously spinning fantastic conspiracy theories reaching back 40 years. Methinks it's straitjacket time.

The process for selecting candidates for the Nobel prize has been so politicised by the left that the prize has — apart from the hard sciences — become worthless.