Economist and historian Robert Higgs has an excellent little piece up titled “Recession and Recovery: Six Fundamental Errors of the Current Orthodoxy”. I highly recommend it. From the article:
the vulgar Keynesian views the capital stock as “given.” If he thinks about it at all, he considers it a sort of massive inheritance from the past and assumes that nothing that might be added to or subtracted from it in the short run will change it enough to warrant concern. But if he gives little thought to capital, he gives none at all to its structure: the fine-grained patterns of specialization and interrelation among the countless specific forms of capital in which past saving and investment have become embodied. In his framework of analysis, it matters not whether firms invest in new telephones or new hydroelectric dams: capital is capital is capital.
Because the structure of the capital stock is disregarded – even sophisticated economists, such as Frank Knight, have insisted that the capital stock is essentially an undifferentiated glob of monetary value, any part of which may be substituted perfectly for any other part of equal monetary value – no attention is given to how changes in the rate of interest bring about changes in the structure of the capital stock. After all, what possible difference can it make? This willful blindness has caused many economists, including the most recent Nobel laureate, Paul Krugman, to misinterpret the Austrian theory of the business cycle as a theory of “overinvestment,” which it definitely is not.
Instead, the theory pioneered by Ludwig von Mises and F. A. Hayek in the first half of the twentieth century – a theory that fell into near-oblivion after the Keynesian Revolution in macroeconomics – is a theory of malinvestment, which is to say, a theory of how an artificially reduced rate of interest leads business firms to invest in the wrong kinds of capital – in particular, in the longest-lived capital goods, such as residential and industrial buildings, as opposed to inventories and equipment with a relatively short life. Thus, in the Austrian view, Fed-induced low rates of interest, like those between 2002 and 2005, lead firms to overvalue longer-term capital projects and to shift their investment spending in that direction, producing, for example, booms in building construction. This shift would make economic sense if the interest rate had fallen in a free market, thereby signaling that people wish to defer more consumption by saving more of their current income. But if people have not in fact changed their preferences in this way and continue to prefer present consumption relatively as much as before, then businesses will make mistakes by choosing these kinds of investment projects, which are, in effect, attempts to anticipate future demands that will never eventuate. When the projects ultimately begin to fail, the boom that artificially lowered interest rates set in motion will collapse into a bust, with attendant bankruptcies and unemployed labor, as unsustainable projects are liquidated and resources shifted, painfully in many cases, to more viable uses.
Because the vulgar Keynesian is blind to these micro-distortions and to the need for their correction in the wake of an artificially induced boom, he will fail to see any need for bankruptcies and unemployment. He supposes: if only the government stepped in and used its own deficit spending to make up for the reduced private investment and consumption spending, then business would be restored to profitability and workers reemployed without any economic restructuring.
It comes as no surprise, then, that people who think along such lines are currently working to continue a policy that contributed greatly to producing the unsustainable boom of 2002–2006, namely, subsidized lending to would-be homeowners who cannot meet normal commercial qualifications for receiving such loans. It does not occur to the vulgar Keynesians that too many resources have been directed into house and condo construction and that lending to homeowners who can afford to purchase homes only if subsidized to do so signals an uneconomic use of resources at the expense of the taxpayers who, directly or indirectly, finance these subsidies.