The Return of Depression Economics
Paul Krugman

Page Contents

Modern Keynesian theory

Monetary policy

Fiscal policy

Latin American financial crises

Japan's liquidity trap

Asian contagion

FUTURECASTS online magazine
Vol. 6, No. 6, 6/1/04.


The dinosaur Keynesian:

  "Bad things happen to good economies." This is the central theme of Paul Krugman in "The Return of Depression Economics," written in 1999. When bad things - domestic and/or international - happen to good economic systems, economic activity contracts, leaving workers unemployed and productive resources unused.

With such  policies - applied as advised by John Maynard Keynes - recessions can be substantially mitigated if not avoided, and financial crises can be avoided or at least contained.


It is illogical to blame the victims of these crises and insist that they perfect their economic policies as a prerequisite for receiving assistance. It is illogical to withhold assistance or delay stimulatory actions while a recession deepens and/or crisis spreads.


How can an economy be good at one moment and bad at the next?



  It is insufficient demand in the private sector that at such times is the root of the problem, according to Krugman. Governments at such times should step in with monetary expansion. They should monetize enough debt to drive interest rates down to levels more attractive for borrowers. This can be coupled with deficit spending programs to employ the productive resources that can in no other way be employed. With such  policies - applied as advised by John Maynard Keynes - recessions can be substantially mitigated if not avoided, and financial crises can be avoided or at least contained.
  Krugman of course does not deny that there were and are weaknesses in economic policies in nations involved in recent monetary and financial crises. He recognizes that the phenomena of "crony capitalism" are economic weaknesses - rather than the bases of successful industrial policy as many Keynesian economists believed. However, he denies that they played any significant role in the Asian Contagion crisis.
  No economic system is managed under perfect economic policies, he correctly points out. All economic systems - even those of the advanced nations - labor under an array of weaknesses in private sector practices and government policy. It is thus illogical to blame the victims of these crises and insist that they perfect their economic policies and practices as a prerequisite for receiving assistance. It is thus illogical to withhold assistance or delay stimulatory actions while a recession deepens and/or crisis spreads.
  Yes, reforms of policy weaknesses are welcome, but they are clearly not essential. After all, didn't these "good economies" perform well - some even expanding exuberantly - just prior to being afflicted by a crisis? How can an economy be good at one moment and bad at the next?
  The policy responses advised by John Maynard Keynes during the Great Depression are thus still advisable. Monetary expansion and government deficit spending to assure demand adequate for full utility of available productive resources is all that is needed to get most "good economies" functioning again at prosperous levels.

  • However, small, soft currency nations that respond to impending crisis by expanding their domestic currencies or running massive deficits in government budgets will invariably suffer a catastrophic flight of capital. For soft currency nations, the establishment of confidence in the domestic currency is always an essential prerequisite for any effort to deal with economic contraction or financial crisis.

  • And once inflation becomes entrenched at substantial rates, Keynesian policies can only make matters worse, even in advanced nations, Krugman acknowledges. Confidence in government and government monetary authorities is an essential ingredient in Keynesian policies and must be restored before they can be applied.

  • And then there is Japan - a very good and advanced hard currency economy - the second largest in the world - rich in monetary reserves. For an entire decade during the 1990s, Keynesian remedies have been employed with great vigor in Japan, without jarring the Japanese economy out of its malaise.

Even cutting the interest rate all the way to zero may still not be enough.

  The limitations of traditional Keynesian policies are thus perforce immediately acknowledged by Krugman.

  "What I meant by introducing the term 'depression economics' was the alarming return of demand failures as a major economic problem. Five years ago economists -- myself very much included -- thought that recessions could always be fought relatively easily: cut interest rates and that will be that. What we learned in the late 1990s was that it wasn't that easy after all. Japan showed us a truth that our grandfathers knew, but that we had forgotten: that even cutting the interest rate all the way to zero may still not be enough. Meanwhile, the troubles of the Asian 'tigers' showed us that small economies, exposed to the gales of international speculation, may simply be unable to cut interest rates to fight an economic slump -- may even feel compelled to raise rates, worsening the slump -- for fear that their currencies will collapse."

  This is hardly a new discovery. As pointed out by the publisher of FUTURECASTS in Blatt, "Dollar Devaluation," back in 1967, Keynesian remedies are just palliatives, not remedies. Even as palliatives, they only work for hard currency nations and only so long as the currency remains hard - which will be a limited length of time since Keynesian palliatives tend to undermine the strength of the currency.

  Even Keynesians must concede that manipulation of interest rates by means of massive monetization of debt has limits - and may ultimately lead to currency collapse - especially for soft currency nations. Even Keynesians must admit that massive reliance on deficit spending to deal with economic problems has natural limits.
  However, this is no more than Keynes, himself, acknowledged 60 years ago. Keynes thus confined himself to analysis of short term impacts - predominantly of closed economic systems. See, Keynes, "The General Theory" (I)
, Part I, "Elements of the General Theory," and Keynes, " The General Theory" (II)., Part II, "Interest Rates, Aggregate Demand, and the Business Cycle." His only prescription for currency devaluation was for ALL nations to pursue Keynesian policies so that no currency would appear stronger than any of the others.
  In Japan, even massive recourse to both low interest rates and government deficits failed.

  "All that money being thrown at the problem has bought the country time, but nothing else. And Japan's government, not so long ago a model of fiscal virtue, is rapidly building up an enormous pile of IOUs. So the time available is limited." (Indeed!)

  Japan has not exactly been completely idle with respect to its fundamental problems. There have been modest reform efforts that, over time, might amount to enough to permit some recovery and restoration of economic growth in and of itself.
  At present, Japan is enjoying an export driven growth spurt due to a vast increase in exports into a rapidly growing Chinese market and a recovering U.S. market. However, China is beginning to have its own problems - with inflation - and is now being forced to cut back. Sometime after the November election, the U.S., too, will have to confront problems with inflation. How well Japan will be able to handle these eventualities remains to be seen.

Perfection is indeed not essential, but substantial improvements in the problems afflicting government policy and private practices are generally recognized as required.

  Other Keynesian economists - like Joseph E. Stiglitz in "Globalization and its Discontents" - have candidly acknowledged the limitations of Keynesian policies as remedies. They now recommend them just for the limited purpose of mitigating the harsh short term impacts of the fundamental reforms that they recognize as essential for recovery from periods of economic dislocation and crisis. Perfection is indeed not essential, but substantial improvements in the problems afflicting government policy and private practices are generally recognized as required.

  Stiglitz is no dinosaur Keynesian.

Reforms of fundamental policies burdening an economic system are nice, but unessential.



  Krugman, however, still views Keynesian policies as first line remedies - sufficient in their own right to cure most economic ailments that result in "unused economic resources" in free market systems. Rationalization of private practices and reforms of fundamental policies burdening an economic system are nice, but unessential. Political leaders should not be bothered with the need to change political policies that burden their economic systems. There is no need to wait until economic contraction forces rationalization of private entity practices.
  At least in advanced, hard currency nations, any failure of Keynesian policies is simply the result of insufficient effort. If zero interest rates and massive deficit expenditures don't do the trick, then negative real interest rates become essential. By purposely generating inflation rates in the 2% to 4% range, real - after inflation - interest rates can be driven below zero - into negative territory - stimulating private sector spending sufficient to utilize all productive resources. 

  Thus, Krugman is perhaps the premier dinosaur Keynesian of the day.

Insufficient demand:

  The return of the Great Depression is unlikely anytime soon, Krugman bluntly states. However, he still invokes the usual left wing scare tactics.

The public will not tolerate business cycle recessions, and only Keynesian policies offer a means to prevent or mitigate them.

  The type of economic problems that afflicted the world during the Great Depression have indeed made "a stunning comeback," he insists. Even without a Great Depression, they can cause enough economic problems to undermine public support for capitalist free market policies.

  The key difference - ignored by Krugman - is the absence of trade war levels of protectionism and the presence of continued globalization. As long as barriers to trade keep declining, nations and private entities will have a chance to service their international debts. This was not the case in the 1920s. See, James, "End of Globalization." Globalization means small free market nations can always devalue - stabilize their currencies at a suitably lower level - and then export their way out of any crisis - as the stricken Asian tigers ultimately did during the Asian Contagion crisis. This possibility, too, was constricted during the trade wars of the 1920s.
  Recovery was far from immediate - and real suffering was imposed on the afflicted populations during the recent crisis periods. However, recovery has nevertheless been surprisingly swift and vigorous - surprising even to Krugman. Krugman was originally of the impression that the recent crises constituted the worst economic reversal since the 1930s.

    Only Keynesian policies can save capitalism from its inherent weaknesses. Only Keynesian remedies can avoid or mitigate the business cycle that inflicts hardships and threatens instability. Only Keynesian policies can make up for the inadequate demand that leaves workers unemployed and economic resources idled during periodic recessions. The public will not tolerate business cycle recessions, and only Keynesian policies offer a means to prevent or mitigate them.

  In fact, the public - even in shaky new democracies - has proven surprisingly resilient. Democracy - imperfect as it undoubtedly is - may not be as fragile a flower as Krugman believes. He expresses surprise at the fortitude of the peoples and governments of afflicted nations. Yet, this is hardly surprising, since they in fact have no better political and economic choices than democracy and capitalism - systems of political and economic freedom.
  Despite the recent economic problems that in some nations were quite severe, democratic processes have continued to function reasonably well in such Asian nations as Indonesia, South Korea, the Philippines, Malaysia, Sri Lanka, India, Japan, and Taiwan. There have recently been peaceful transfers of power in many of these nations as the people exercise their rights to "kick the bastards out."
  The U.S., itself, as a fragile young republic, suffered through numerous recessions and depressions during the 19th century - without surrendering its political freedom.

  Krugman insists that the problems of insufficient demand - private demand levels insufficient to employ all available productive capacity - have returned as essential features of capitalist systems. Without saying so, he is asserting the old Marxian and Keynesian stupidity of "mature economy" problems.

  "For the first time in two generations, failures on the demand side of the economy -- insufficient private spending to make use of the available productive capacity -- have become the clear and present limitation on prosperity for a large part of the world."

  The Keynesian savings gap is an obvious stupidity - a stupidity Keynes picked up from Marx. There is no problem with savings during prosperous times in advanced capitalist systems with functioning financial systems. Banks with access to financial and money markets have no trouble circulating all savings during prosperous times. Moreover, people save less - not more - as they become wealthy, since they can and do depend more on their asset wealth for reserve purposes. Savings rates decline as capitalist nations become wealthier.
  Whenever there is such "insufficient demand," there are always fundamental reasons for it - reasons which dinosaur Keynesians always ignore. Insufficient demand never causes recessions in advanced market economies with properly functioning financial systems. Recessions cause insufficient demand.

  Keynesian monetary policies have in fact been very successful in the last two decades in mitigating recessions and assuring prosperity, Krugman correctly points out. But that success has been limited to hard currency nations like the U.S. However, Japan shows that even major hard currency nations - even Europe or the U.S. - can run into the problems of insufficient demand.
  A host of developing nations have recently experienced recessions that at least temporarily undid years of economic progress. These nations found that "the conventional policy responses only make matters worse." Once a crisis develops, it has to run its course before recovery can begin.

  "Once again, the question of how to keep demand adequate to make use of the economy's capacity has become crucial. Depression economics is back."

  Just a couple of years later, it became apparent that Krugman's expectations were clearly in error. As FUTURECASTS has been pointing out since its February 2002 Near Futurecast, it is problems of inflation that the U.S. is heading towards. The February 2003 Near Futurecast emphasized that it is problems similar to those of the 1970s that the U.S. and the dollar-dependent world is currently heading towards. These are problems of inflation, stagflation and economic volatility caused by Keynesian policies - not problems of deflation and depression similar to those of the autarkic1930s.

  "Five years ago [about 1995] hardly anybody thought that modern nations would be forced to endure bone-crushing recessions for fear of currency speculators; that a major advanced country could find itself persistently unable to generate enough spending to keep its workers and factories employed; that even the Federal Reserve would worry about its ability to counter a financial-market panic. The world economy has turned out to be a much more dangerous place than we imagined."

  The Federal Reserve can only be as strong as the dollar. As the dollar weakens, so does the capabilities of the Fed.

   The startling speed of recovery of the stricken Asian tiger economies was just beginning in 1999 when Krugman was writing. By 2000, however, when writing the Introduction to the paperback edition, he could site that rapid recovery - occurring despite very modest reform efforts - as proof that the crisis was not a punishment for fundamental sins, but just a simple financial panic. "Bad things have lately been happening to good economies," Krugman again asserted.

  The extent of recent Asian economic problems has not, in fact, been unrelated to the quality of their economic polices. Hong Kong, Singapore and Taiwan did not suffer currency and financial collapse despite the problems of their neighbors. The speed and extent of recovery has, in fact, been observably related to the extent of fundamental reforms, with Indonesia predictably trailing the pack. The most obvious reform forced by the crisis was the liquidation of much of the heavy debt burdens - especially the short term foreign currency debt burdens - previously widely assumed by Asian businesses. 

Krugman acknowledges that the 1980-1982 depression was an essential factor in defeating inflation and creating the conditions for the subsequent two decades of prosperity.

  The business cycle is a threat that is intolerable, and threatens the capitalist free market system, Krugman warns. "[Generally] free markets, with all the benefits they bring, are unlikely to survive in a world where insufficient demand is a continual threat." (Is there a better alternative?) Only Keynesian policies can assure adequate demand and save the free market system from being undermined by its business cycle.

  This is a familiar theme for Keynesians. Some had expressed doubt that the 1970s stagflation could ever be eliminated. How could the fragile public of a democracy ever stand for the depths of recession - indeed, depression - needed to bring the 1970s inflation under control? However, in the 1980s, strong leadership in all the major Western nations adopted harsh austerity measures sufficient to counter the worst of the inflationary pressures loosed by the Keynesian policies of the previous two decades.

  In an earlier book, "Peddling Prosperity," Krugman castigated the conservative leadership for imposing so much pain on the public.  He actually took umbrage that political leaders in all the major industrial nations decided to spend the political capital needed to put their economic systems through that wringer - slyly without publicly acknowledging in advance just how harsh such austerity would be.

  Somehow, he neglects to blame the Keynesians for generating the stagflation mess in the first place. Somehow, he neglects to castigate Keynesians for slyly omitting mention of the dangers of stagflation - inflation that causes unemployment - that must arise from aggressive use of Keynesian policies.

  Yet, Krugman acknowledges that the 1980-1982 depression was an essential factor in defeating inflation and creating the conditions for the subsequent two decades of prosperity.

  Krugman's record as an economic forecaster includes both successes and failures. He was among the earliest economists to recognize that the rapid growth initially enjoyed in developing countries as they begin freeing people for free market wage labor is self-limiting in the absence of the ability to generate substantial productivity gains with their investments. Most notably, the Soviet Union hit this wall with spectacular results.
  However, in the early 1990s, in "Peddling Prosperity," Krugman also predicted the quick failure of the European Monetary Union. At the same time, he predicted a slowdown in U.S. productivity growth after 1995 as a consequence of the social spending budget cuts of the Reagan Administration in the 1980s. Now he tells of his surprise at the limits of the effectiveness of standard Keynesian policies.

A little inflation is a good thing:



  Inflation at low levels is the appropriate Keynesian remedy for problems such as those of Japan. This advice has been a feature of Krugman's writings for some time, now. Keynes agonized - irrationally - over savings rates and struggled with methods of getting people to save less and spend more. Krugman, like many Keynesians, continues along this line.

If the Japanese people refuse to spend enough to regenerate economic growth, inflation at somewhere between 2% and 4% should be generated to induce them to spend more and save less.

  Interest rates can be driven below zero in real terms if there is some inflation, Krugman points out. This would overcome the natural limitation of monetary policy when interest rates hit near zero. Below zero real interest rates should  encourage borrowing for both investment and consumption. If the Japanese people refuse to spend enough to regenerate economic growth, inflation at somewhere between 2% and 4% should be generated to induce them to spend more and save less.
  In their desperation, Japanese officials were beginning to view this recommendation with increasing favor. Only the Bank of Japan was holding back.

  "To visit Japan today is to understand how Keynes must have felt. What foolish things sober men can say and do in the name of sound policy!"

  Fortunately, the export boom into the growing Chinese market and the expanding U.S. economy has come along in time to remove any apparent need for an attempt to apply inflation as an economic remedy in Japan.

Standard Keynesian policies can admittedly fail to generate the promised growth. The name for this is a "liquidity trap."

  Krugman acknowledges that there may be risks in his radical solution to Japan's problems. However, he argues that the years of vast deficits in the government budget incurred in futile efforts to spend Japan back to prosperous growth are not, in fact, without considerable risks in their own right. Japan's public debt load is reaching proportions sufficient to alarm even Keynesians.  Even when forced to recognize that Keynesian policies have limitations and risks, Krugman typically fails to analyze those limitations and risks. Keynes, himself, recognized that his standard low interest monetary expansion policies can fail to generate the promised growth. Keynesians even have a name for this failure: a "liquidity trap."

  However, there is little desire to examine other problems and unintended consequences flowing from their policy recommendations. During the stagflation of the 1970s, inflation and unemployment both rose alarmingly at the same time, and economic volatility increased instead of succumbing to Keynesian policies. This evident failure is now breezily written off by Krugman as just an initial mistake in pushing too hard for levels of employment that proved to be inflationary. Once inflation gets entrenched, he acknowledges, it becomes a real problem.

  Krugman generally glosses over the many problems and dangers of inflation. The anemic productivity and economic growth of the two decades after the 1972 and 1973 devaluations of the dollar just happened to coincide with two decades of the highest inflation rates in peacetime U.S. history.
  Krugman doesn't even deign to recognize the connection much less discuss it. What does inflation do to cause such malaise? In fact, inflation doesn't prevent unemployment, it always ultimately causes unemployment. In fact, no nation has ever prospered with chronic inflation rates as high as 4%. In fact, at 4% compounded for 10 years, the Japanese people would lose the equivalent of half their savings. How would the electorate respond to that?
  One of the unique problems of inflation is that there is no straightforward way of ending it. Austerity is the only remedy, and austerity means a period of recession or depression must first be endured before healthy economic growth can resume. The efforts to achieve a "soft landing" from the inflation pressures that built up in the 1970s required (1) above average real interest rates, (2) a depression during 1980-1982 and (3) a mild recession in 1991, and (4) notoriously lackluster economic performance until the middle of the 1990s. That's why inflation is so dangerous. See, "Understanding Inflation."

  The failure of massive budgetary deficits and low interest rates during the 1930s is explained away as having been insufficient to induce recovery from the Great Depression. The U.S. government was just too small during the 1930s for its budget deficit to have the desired stimulatory impact. It took WW-II levels of spending to jar the economy out of the Great Depression, Krugman confidently asserts.

  In fact, recovery from the Great Depression in the U.S. began immediately after war began in Europe. It was stimulated by a flood of exports to France and England and to the export markets that they could no longer service. Recovery was thus clearly observable many months before U.S. defense spending began to pick up. The loss of export markets due to the trade wars of the 1920s and 1930s was a primary factor preventing economic recovery, and that ended with the start of war in Europe.
  That the Great Depression did not return after demobilization and the cutback in WW-II military spending as many Keynesians and other leftists confidently expected is now conveniently forgotten. Also ignored is the removal of trade war levels of protectionism. This permitted the post WW-II expansion of international trade and was a primary factor assuring  post WW-II prosperity. See, Great Depression, Depression mythology, and the Depression Chronology series beginning with Great Depression, The Crash of '29.
  Keynes recognized the importance of ending the trade war levels of protectionism. To his great credit, after WW-II, he and some of his followers played an important role in beginning the process of removing those trade restraints and in the creation of institutions to facilitate expansion of international trade.
  The unintended consequences of a long stretch of inflation at as much as 4% per year are not considered by Krugman. Krugman is like a doctor prescribing powerful drugs without seriously considering possible side effects.
  By definition, the desired rate of inflation has to be high enough to change public expectations and alter public conduct. Will public response be only along desired lines? And if implementation of government policy is as usual considerably less than perfect, will Japan find itself in the stagflation morass experienced by the U.S. in the 1970s - with a 1980-1982 level of depression required to regain control - and Krugman wringing his hands over the human suffering caused by such austerity?
  Will asset price bubbles again begin to inflate, as frequently occurs when interest rates are artificially low and credit policies are dangerously loose? After all - lacking positive interest rates - there is no time cost of money to guide investment decisions. Lacking positive interest rates, oil and other minerals in the ground become more valuable than if produced and sold. As interest rates inevitably rise in the U.S., the asset price bubble response to recent artificially low interest rates may indeed become a serious problem.

Good economies:






  Heavy reliance on debt capital was a common feature of all the economic systems recently afflicted with financial panics, Krugman acknowledges.

  A capital structure heavily laden with debt resting on a slender foundation of equity - ownership - capital has been a classic prescription for economic trouble for millennia. When economic activity slackens, equity capital has a substantial ability to flexibly contract and survive until recovery becomes possible, but debt capital is relatively inflexible - like glass. Debt shatters under pressure.

With incredible hubris, Keynesians assert that Keynesian policies can abolish or limit the business cycle and make the world safe for even the heaviest reliance on debt capital. Thus, the capital structure of the stricken nations was not in Krugman's eyes a fundamental weakness.

  However, Keynesians deny that this is an unavoidable weakness. With incredible hubris, they assert that Keynesian policies can abolish or limit the business cycle and make the world safe for even the heaviest reliance on debt capital. Thus, the capital structure of the stricken nations was not in Krugman's eyes a fundamental weakness.

  Only the presence of thick layers of equity capital to shield debt capital from the expectable stresses of economic life can make debt capital relatively safe in the face of such stresses. Keynesians determinedly ignore this irrefutable fact of economic history.
  During the 1970s, there were Keynesians who doubted the need for any ownership interest and ownership capital. They accepted the Marxian stupidity that shareholders of major corporations were functionless and that dividends paid were therefore a waste of corporate resources. Modern management had no need for the disciplines of the ownership interest. Debt capital or even government ownership was with incredible stupidity viewed as sufficient.

  However, even Keynes and his followers acknowledge that foreign debts can be a problem. Even worse, Krugman notes, are debts denominated in hard foreign currencies like dollars and yen. Still worse than that is when such debts are short term and require repeated refinancing.
  All of these elements characterized much of the debts that collapsed during the Asian Contagion crisis, and subsequently in Argentina, Krugman acknowledges. Much of this was in one way or another liquidated before recovery from the crisis.

  Yet Krugman insists that these were all "good economies" that bad things happened to for no good reason. He erroneously insists that recovery occurred without substantial reform of fundamental problems, and argues that this proves that the crises could not be blamed on fundamental problems.

  But such debts have been stimulating apparent economic prosperity and then crashing spectacularly throughout economic history - and the liquidation of much of them is clearly among the reasons for the rapid and strong subsequent recovery of most of the nations afflicted in recent crises.
  Heavily indebted economic systems are not "good" economic systems. Boom and bust is an age old characteristic of such systems. Over 90% of the capital flowing into the Asian tiger economies prior to the crisis was debt capital. This is not a weakness that economies can endure and remain "good."

  Total factor productivity problems are another fundamental weakness that can undermine apparently prospering economic systems, Krugman acknowledges. Indeed, his recognition of the importance of this factor is one of his most notable successes as an economic commentator. He provides some cogent explanation of this factor.
  Some economic systems are clearly able to get more productivity from their investment money than others. The U.S. gets a lot of productivity from its investment dollar. The Soviet Union got almost none. Productivity-deficient nations can still grow - even rapidly - simply by shifting housewives and non-wage peasants into wage labor - but there are obvious limits to such growth - as the Soviet Union found out. The calculation of an abysmally low total factor productivity growth "provided the first early warning of troubles to come" in the Soviet Union.

The "Asian System" was successfully mobilizing available material and human resources, but was not using them efficiently.

  Similarly with emerging Asian nations. A couple of academic researchers have demonstrated that there was "hardly any productivity growth" behind the emergence of several rapidly growing Asian nations. Krugman was one of the few to recognize the importance of this research prior to the Asian Contagion. There were many authoritative voices with vested interests in denying the implications of this research. As usual, they twisted the statistical data to make it deny the truth. Except for Hong Kong and Taiwan - two little states that avoided the panic despite existing in the eye of the storm - the Asian miracles were not real miracles.
  As with the Soviet Union, the sluggishness of productivity growth "raised questions about the effectiveness of economic management in general" in these nations, Krugman points out. (Wouldn't this necessarily involve a whole array of fundamental problems - including those arising from crony capitalism?) The "Asian System" was successfully mobilizing available material and human resources, but was not using them efficiently. Instead of catching up technologically, they were falling further behind.

  As a theoretical matter, developing nations that  fail to benefit from "second mover" advantages - that are not improving productivity any faster than the averages for developed nations - might adjust smoothly to this factor - just losing growth momentum and beginning to stagnate. With sufficient economic flexibility, periods of panic and collapse are not theoretical inevitabilities.
  However, several of these nations were actually falling behind at significant rates. At some point, the adverse impacts on their schedule of comparative advantage - coupled with their typical lack of economic flexibility - must bring on an economic crisis that will force required adjustments.

  Even those that are just keeping pace will as a practical matter suffer from their limited economic flexibility when their rate of growth begins to decline. The adjustment process will inevitably not be a smooth one.

  Yet Krugman insists that these were all "good economies" that bad things happened to for no good reason. Doesn't the total factor productivity factor explain how a defective economy can expand exuberantly one moment and crash the next?

  Economic systems with little growth in total factor productivity are not "good" economic systems. As Krugman himself so well explained, exuberant growth at one moment is no indication of health in such economic systems. Any economy expanding faster than its rate of productivity growth  must eventually hit a wall. This is not a weakness that economies can endure and remain "good."

Government misallocation of available credit discouraged productivity and encouraged speculation. There is a pervasive moral hazard aspect to crony capitalism. The vast inflow of debt capital was being directed according to political rather than economic factors, without any sense of risk.

  Crony capitalism does in fact involve some very unhealthy practices, Krugman somewhat inconsistently concedes when discussing the Asian Contagion crisis. Government misallocation of available credit in these nations discouraged productivity and encouraged speculation. There is a pervasive moral hazard aspect to crony capitalism. The vast inflow of debt capital was being directed according to political rather than economic factors, without any sense of risk.

  "Throughout the region, then, implicit government guarantees were helping underwrite investments that were both riskier and less promising than would have been undertaken without those guarantees, adding fuel to what would probably anyway have been an overheated speculative boom."

  Ultimately, the vast majority of foreign lenders were in fact bailed out by the governments of the afflicted nations.

  Economic systems heavily influenced by political considerations - by government industrial policy - are not "good" economic systems.  Such economic systems invariably run into severe economic problems, no matter how well they may perform initially. This is not a weakness that economies can endure and remain "good."

Krugman ignores the cumulative nature of various economic problems.

  Indeed, there are a variety of fundamental problems that characteristically provide an initial illusion of healthy growth before inevitably suffering varying degrees of failure. Inflation gathers steam over time, debts grow until they reach unsustainable levels and are impacted by the inevitable onset of downward movements in the business cycle, regulatory costs and/or taxes grow to unbearable levels, etc. Also, as Krugman so eloquently explains, factors of growth unassociated with productivity gains eventually reach their limit.
  Only during periods of economic stress are private business leaders and public policy makers forced to confront such problems. Krugman, himself, is one of the problems - offering a politically attractive easy way out - which can only make matters worse over time.

  Krugman responds:

  "There is no good reason, however, why misguided investments in the past should leave perfectly good workers unemployed, perfectly useful factories idle. If the U.S. stock market should crash tomorrow, nobody would expect Alan Greenspan to shield stockholders from their losses; but we would and should accuse him of malfeasance if he did not do everything possible to keep those paper losses from causing mass unemployment."

  Greenspan, indeed, did do all he could do during this last stock market decline and economic recession that began after publication of this book. He undoubtedly mitigated the effects of the last recession. However, he could neither prevent substantial growth in unemployment nor hurry the pace of recovery.
  And his efforts were not without cost - in terms of a substantially devalued dollar and a corresponding adverse shift in the terms of trade for the U.S. Now, price inflation and rising interest rates are being added to the noxious results of these efforts. Now, a weakened dollar and rising interest rates will limit the vigor and threaten the sustainability of economic recovery.

  Latin America:



  The drearily repetitious series of economic failures that have afflicted many Latin American nations is discussed by Krugman. With a few exceptions, too much debt and too much paper money along with a variety of mercantilist and other economic ills have repeatedly thwarted economic stability and growth throughout the region. What today is called "industrial policy" consistently runs amok.

Disturbingly, despite massive capital inflows - heavily weighted towards debt - there was little actual growth.











  Efforts to restore confidence in peso currencies and bring down inflation by fixing exchange rates were successful in the 1980s. However, massive levels of government and private borrowing remained the rule. The result of "a boom in credit - - - was a huge excess of imports over exports." Disturbingly, despite these massive capital inflows - heavily weighted towards debt - there was little actual growth.
  The fixed currency exchange rates that had cured the problems of inflation thus themselves soon became a problem. They were unsustainable in the face of so much debt and balance of payments deficits. Currencies were becoming increasingly overvalued and were pricing domestic goods out of export markets.
  Mexico and then Argentina were ultimately thrown into crisis and forced to devalue. Inevitably, mistakes were made, demagogic politics intervened, and the crises were thus made far worse than they had to be.
  Krugman provides a standard explanation for how debt capital - lacking the flexibility of equity capital - can shatter in a crisis. Problems in Mexico quickly undermined confidence in Argentina as credit contraction spread across Latin America. After devaluation, massive stabilization funds - $50 billion for Mexico and $17 billion for Argentina - stabilized the financial situation. The crisis resulted in seriously depressed economic conditions, but stabilization permitted rapid recovery. As usual, both crisis and recovery caught many by surprise.
  For Krugman, the key question is:

  "Why was so large a punishment imposed for so small a crime?"

  The answer is obvious. Debt capital is inflexible like glass, and can shatter under stress - as it has innumerable times throughout economic history. Fixed exchange rates provide significant advantages, but they, too, can shatter if lack of budgetary and/or monetary discipline permits deficits to grow in a nation's international  payments.

  "We should have taken [this] question -- with its implication that there were mechanisms transforming minor policy mistakes into major economic disasters -- to heart. We should have looked more closely at the arguments of some commentators that there really were no serious mistakes at all, except for the brief series of fumbles that got Mexico on the wrong side of market perceptions, and set in motion a process of self-justifying panic. And we should therefore also have realized that what happened to Mexico could happen elsewhere: that the seeming success of an economy, the admiration of markets and media for its managers, was no guarantee that the economy was immune to sudden financial crisis."


  Even major advanced nations like Japan can and do get into economic trouble. However, as long as they have access to world markets and adequate monetary reserves, they don't collapse. But they can stagnate and decline.

The government provided massive amounts of deficit spending and drove interest rates near zero - the prescribed Keynesian response - but without observable effect.

  The extent of Japan's problems are unjustified, Krugman again asserts. He explains the expansion and collapse of Japan's bubble economy, and the roles played by such factors as loose bank credit, moral hazard, and Japan's mix of industrial policy.
  However, Japan's bubble crisis did not collapse the entire economy. Japan is a wealthy nation with extensive financial reserves. There was thus never any panic. The economy just stagnated - for an entire decade. A "growth recession" extended into a "growth depression" as unemployed workers and resources slowly increased.
  Why has Japan failed to recover, Krugman asks as of 1999. The government provided massive amounts of deficit spending and drove interest rates near zero - the prescribed Keynesian response - but without observable effect.
  The Japanese people are on a savings binge, is Krugman's answer. The financial system is not efficiently circulating these massive savings. There is thus a "liquidity trap" that prevents successful application of Keynesian policies. He recognizes Japan's banking problems. Efforts to recapitalize troubled banks were insufficient to restore growth.|

  Krugman repeats his prescription for curing this "liquidity trap" ailment. Just expand the money supply so vigorously that inflation will reach about 3% or 4%, and the Japanese people will rush to spend their yen before it devalues.

  The Japanese financial system is clearly dysfunctional. It does not efficiently circulate the nation's savings. Its lending has been politically directed, leaving many small businesses without ready sources of credit, and all the large banks bearing heavy loads of non performing loans extended on the basis of political influence.
  The artificially low interest rates make it impossible for ordinary Japanese people to find safe ways of earning a decent return on their savings. Under such circumstances - typical of many Asian nations - people MUST save much more for their retirement than is needed in the U.S. where people can depend on their investment income to cover most of their retirement needs.
   It is evident that, under such circumstances, low levels of inflation would just raise the savings bar. People cannot avoid preparing for their retirement needs. They would just have to save more, or be driven to alternatives that would be even worse for Japan.
  As Krugman desires, they might  give up on saving - increasing their dependence on government and private pensions for their retirement needs. Japan is already in trouble on this score - one of many problems Krugman ignores. Or they might be driven to pursue investment fads - generating asset bubbles such as have always been typical of capitalist nations during periods of loose private or government credit policies.
  Or they might send their savings to Europe. The euro is today the most reliable major currency. They might buy gold as an alternative to saving. In these two latter cases, capital flight would quickly be added to Japan's problems.

The Asian Contagion:

  Krugman sketches the 1990s boom and bust in Thailand. He explains how a collapse of the Thai currency - the baht - initiated the Asian Contagion crisis.

"By early 1996, the economies of Southeast Asia were starting to bear a strong family resemblance to Japan's bubble economy of the late 1980s."

  Money poured in to Thailand and other emerging Asian markets - principally from Japan and Europe - to take advantage of higher interest returns. This fueled an expansion of available credit of massive proportions. Government efforts to maintain fixed currency exchange rates prevented appropriate adjustments in the money markets that might have mitigated the impacts.

  "By early 1996, the economies of Southeast Asia were starting to bear a strong family resemblance to Japan's bubble economy of the late 1980s."

  Currencies had been fixed to defeat inflation, reduce interest rates, and encourage the inflow of badly needed foreign capital. However, the flow was predominantly - more than 90% - debt capital, as there were many legal and financial problems in these nations that discouraged equity capital. Massive amounts of debt capital were piling onto a very narrow - shaky base of equity capital. Moreover, much of it was denominated in dollars or yen, to further reduce interest rates.

  With currency rates fixed, other efforts to curb the credit boom and the rampant speculation that it encouraged failed. After all, for small nations with weak currencies, currency volatility has its own burdens and risks, so the exchange rates remained fixed.
  An unbalanced boom ultimately began to suck in imports. Costs were pushed up, slowing export growth. The resulting deficits in international payments grew to ominous proportions.
  Despite recognizing these not inconsiderable problems, Krugman still maintains that these were essentially "good" economies.

Debts are different from equity. They have to be serviced and refinanced in bad times as in good, and thus are at risk of shattering during any crisis.

  The crisis - which hit on July 2, 1997 - was preceded in Thailand by a period of decline as speculative investments began to go bad and creditors began to withdraw money. "Even before the July 2 crisis, land and stocks had fallen a long way from their peaks."
  The Thai government was faced with the usual conundrum of such situations. As reserves dwindled, continued defense of the baht required higher interest rates and an economic recession that would cut imports. However, devaluation looked no better, since so many debts were denominated in dollars and yen. Many financial institutions would be driven into insolvency by devaluation.

  A devaluation has other nasty side effects even without this particular problem. It may become a necessary part of the remedy for an overvalued currency, but it is never by itself sufficient - and it is never cost free.
  Devaluation must be accompanied with sufficient fundamental reforms of the factors responsible for undermining the value of the currency, or there will be an unending series of forced devaluations. The danger of repetitive devaluation must be countered by convincing reforms or it will increase perceptions of risk that will undermine capital formation or even accelerate capital flight. Moreover, each devaluation constitutes a major adverse shift in a nation's terms of trade - reducing domestic productivity and forcing the nation to expend more economic resources to pay for its imports.

  As usual in such cases, capital fled the stricken currency, eventually forcing the issue when reserves ran too low to prevent devaluation. Krugman provides the details and then asks: "Why should a devaluation in one small economy have provoked a collapse of investment and output across so wide an area?" And, why were governments so helpless to prevent the spread of the crisis?

  However, neighboring states with sounder financial postures - like Singapore and Taiwan - did not collapse. As Krugman relates, tiny Hong Kong was far from helpless in fending off a determined speculative attack on its currency and stock market.

  Krugman answers the first question by describing the shattering typical of a highly indebted economy when faced with some substantial economic stress. Debts are different from equity. They have to be serviced and refinanced in bad times as in good, and thus are at risk of shattering during any crisis. This they did during the Asian Contagion, as Krugman explains. That so much debt was denominated in dollars and yen and was short term just made things much worse - as it historically always has.

  Krugman takes the Keynesian view. This is just the instability that can normally be expected in a market economy.

  However, he never deigns to explain how much more resilient these economic systems would have been with more equity and less debt. If the business cycle is a normal part of market economies - as it obviously is - then it is the height of stupidity to assert that heavily indebted economic systems are still "good" economic systems.






  However, the economies of such nations as Indonesia and South Korea were very different in their basic characteristics, Krugman emphasizes. They all had their flaws - as all economic systems do - but why did they all suffer collapse? What was it that made such different economic systems subject to panic?

  Krugman neither notes nor asks why tiny Singapore and substantial Taiwan were able to absorb the blows of the crisis in their neighborhood without collapse.

"They had also grown vulnerable because they had taken advantage of their new popularity with international lenders to run up substantial debts to the outside world."

  These nations had all opened up their financial markets. They had all recently sought - and benefited greatly from becoming - free market economic systems.

  "And they had also grown vulnerable because they had taken advantage of their new popularity with international lenders to run up substantial debts to the outside world. These debts intensified the feedback from loss of confidence to financial collapse and back again, making the vicious circle of crisis more intense. It wasn't that money was badly spent; some of it was, some of it wasn't. It was that the new debts, unlike old ones, were in dollars -- and that turned out to be the economies' undoing."

  Precisely! So why does Krugman act as if this panic was so inexplicable? That is precisely what happens to entities that become heavily indebted.

  However, was there something policy makers could have done to avert or mitigate the damage?

Hard and soft currencies:

  There is a double standard imposed by "psychological" factors in the world's money markets. When first world nations - with hard currencies - get into financial trouble, investors expect the process to be "self-limiting." They begin bottom fishing. They view the crisis as a good opportunity to invest in the inevitable recovery. They thus help to limit the damage and facilitate that recovery.

  However, when third world nations - with soft currencies - get into financial trouble, investors fear a total crackup - perhaps even political disintegration - and head for the exits.

  This is not a matter of large and small. Nor is it difficult for third world nations to achieve first world economic status. There are no smaller states than Singapore and Hong Kong. Such nations as Taiwan, Costa Rica, and Chile have had their ups and downs without suffering shattering panics.
  On the other hand, even the mightiest of economic powers - Great Britain in the 1930s and the U.S. in the 1970s - can suffer rapid currency devaluations which can leave them financially and economically weakened for a decade to come.

Keynesian palliatives are feasible only in hard currency nations where investors have confidence in the long-term purchasing power of the currency.

  Unfortunately, Keynesian policies are unavailable to third world nations because their currencies are soft, Krugman grieves. Confidence in soft currencies can evaporate if interest rates are pushed below market rates by means of monetary expansion and the monetization of massive amounts of debt. High levels of debt in soft currency nations make investors nervous (as they should).
  Keynesian palliatives are feasible only in hard currency nations where investors have confidence in the long-term purchasing power of the currency. Even when hard currencies begin to slide, the slide is generally gradual and self-limiting, rather than panicky and catastrophic. This enables the U.S. to maintain low interest rates and incur growing deficits in government budgets for some years to ease conditions while its economy works its way through and out of a recession.

  This is not exactly cost free and painless. Not only is the nation burdened thereafter with higher debt loads - inevitably much of it held abroad - but the devaluation of the dollar means an adverse shift of sizable proportions in the terms of trade. U.S. workers now have to work much harder not just to pay for their oil imports, but for all their industrial metals and many other imports as well. Price inflation in industrial commodities is currently running well above 30%, while Europe with its strong euro enjoys much lower levels of price inflation in these commodities.
  And now - inevitably - price inflation is becoming general and higher interest rates unavoidable - posing serious problems for any highly indebted economy.

  Did the IMF bungle its response to these crises? Krugman correctly notes that it did -- and even more correctly notes that it didn't really matter that much, since the IMF lacked the ability to avoid these crises in any event.

Evil speculators:

  Keynes - like Marx before him - accused evil speculators of causing many financial problems. They are the ones that undermine confidence in weak currencies and block the use of Keynesian policies in soft currency conditions.

  Krugman provides a chapter on these evildoers and their activities during the recent crises. However, his account is far better nuanced and more realistic than that of Keynes - or of course, Marx. He explains how Hong Kong fended off a speculative attack on its currency and stock market.

  Thank god for the speculators. They precipitate the onset of crisis before fundamental problems get even worse - and bring crises to a quick end by bottom fishing when the causes of the crisis are sufficiently liquidated. Krugman, himself, provides an example of how this works.

  However, they can precipitate the failure of Keynesian policies even in hard currency nations like the U.S. Public and private activities that generate massive debts can collapse - and repeatedly have collapsed - catastrophically even in hard currency nations, and speculators are always alert to take advantage of such opportunities.

  The real psychological problem is not one of fear, but of complacency. Investors are optimists who want to believe they can make money, as Keynes shrewdly noted. Thus, markets generally withstand the growth of obvious risks far longer than they should - explaining the panicky collapses that frequently occur when investors suddenly realize the risks that have been developing.
  For one prominent example - it took the stock market more than a year - until December, 1930 - to decline to levels that no long were discounting a likelihood of a normal recovery from the Great Depression. See, Great Depression, Depression mythology, Part E, "Irrational Pessimism."









  The prospects for recovery as of the writing of this book (1999) are provided by Krugman.

  "One of the truly surprising things about the rolling financial crisis of the past two years -- or the past five years, if one regards the tequila and Asian crises as a single story -- is how well the afflicted countries have behaved, how willing they have been to abide by the rule of the New World Order. For the most part governments meekly accepted the view that the crisis was a punishment for their sins, or at any rate that there was no alternative except to follow the straight and narrow until investor confidence returned. Even Malaysia's Mahathir, while avoiding becoming an IMF client, was persuaded to adopt more or less orthodox austerity policies and accept the resulting slump."

  Malaysia tried some modest capital controls and fooled the skeptics by beginning to recover anyway. However, all the stricken Asian tigers began to recover at the same time, with Indonesia the clear laggard in both the extent of its reforms and the pace of its recovery. Krugman candidly concedes that the impact of the mix of policies pursued by Malaysia is thus not clear.

  This is a commendable candidness indeed since Krugman was one of the few economists at the time advising resort to some controls on capital flows, and he could easily have claimed some credit for apparent success. Malaysia - and Chile, which also had some modest controls on capital flows - have since moved away from such controls.

  However, then came the crises in Russia and Brazil. This left Krugman wondering, "Who's next?"
  Krugman canvasses the world for possible targets. Because it is so close to Brazil, he views Argentina as a real possibility for  crisis as of that time - despite being "basically well run."

  How can Krugman consider a nation with Argentina's dysfunctional government budgetary systems "well run?" In the event, Argentina did indeed collapse.

  China, Japan - even the U.S. - may be hit. However, these are just scenarios. Krugman wisely makes no predictions.

Krugman's policy remedies:



  A little bit of inflation becomes an important part of Krugman's policy recommendations. By maintaining inflation at about 2%, real interest rates can always be driven as low as minus 2%.

  This was actually done in the 1970s - with nasty results. A "little" inflation is a tricky thing to keep in check - especially considering the inherent inaccuracy of official statistics.

  Some fundamental reforms are viewed as advisable - for the long term. Safeguards against hedge fund excesses and some limitations on reliance on foreign debt are eminently sensible recommendations.

  "[My] own suggestion is that governments actively try to discourage local companies from borrowing in foreign  currencies, and also perhaps from relying too much on borrowed funds in general - that is, reduce their 'leverage.' The best way to do this is probably by taxing companies that borrow in foreign currency. In so doing, countries might regain the ability to allow their currencies to slide without provoking a financial collapse and, in so doing, head off future crises at the pass."

  Heavens forbid a Keynesian should advise the importance of facilitating and attracting equity capital.

Two to four percent inflation will cause no harm to advanced hard currency nations.

  For hard currency nations, whenever crisis approaches, interest rates should be cut "drastically without hesitation" to prevent the establishment of the dreaded "liquidity trap." Two to four percent inflation will cause no harm to advanced hard currency nations.

  It will also conveniently make it easier to handle heavy debt loads - until long term interest rates inevitably begin to rise.
  Governments love inflation. It is the easiest way to appropriate a percentage of a nation's produce for government purposes. It is a tax by use of the printing press. Krugman's Keynesian advice is thus music to political ears.
  Because of the massive reliance on debt capital in most modern nations, even modest levels of price deflation are feared. Price deflation increases real interest rates above nominal rates and makes it harder to bear the burdens of debt. In the absence of heavy debt loads, price deflation provides a very healthy increase in purchasing power without the noxious impacts of monetary expansion. Price deflation is actually one of the most powerful natural market mechanisms for bringing economic systems out of recession.
  Any system that cannot benefit from the increased purchasing power of modest levels of price deflation is a system that is too heavily in debt. During the 19th century, the U.S. grew to become the wealthiest nation in the world while enjoying modest levels of price deflation at about 1 1/2% per year. Truly well run capitalist systems that encourage the investment of equity capital have nothing to fear - and indeed gain many benefits - from such levels of price deflation.

  For soft currency nations, Krugman admits having no easy answers. Defending an overvalued currency by raising interest rates can be catastrophic, he correctly points out. Devaluation has major costs in terms of loss of confidence, especially if further devaluations are expected. (The resulting adverse shift in the terms of trade is never mentioned by Krugman.) Capital controls may be the least bad choice. 

  Capital controls, by themselves, are also a totally ineffective remedy.
  There are always reasons - almost always involving inept government policies - when pegged currencies become overvalued. Heavens forbid Krugman should analyze such policies and confront political leaders with the need to change some that are politically attractive but that are economic blunders. Heavens forbid that he should emphasize the need for governments to accommodate commerce in general and the investment of equity capital in particular.

The babysitting coop:

  To demonstrate how "liquidity traps" work, Krugman loves to use the experience of a baby sitting coop in Washington D.C. The coop issued an initial amount of scrip that could be used to obtain baby sitting services. However, it ran into trouble when everyone tried to save up scrip for future needs, causing a baby sitting depression. This was "solved" by the issuance of additional scrip. This is supposed to show how monetary expansion can solve "liquidity traps."

  The weaknesses of this model are obvious. First, it is an administered pricing system, not a market pricing system. Second, there is no competition involved. Third, there is no financing system or investment system to circulate savings. Fourth, there are no interest rates to establish the time cost of the scrip. Fifth, there is no trade with outside systems. Sixth, there is no money market to vary the purchasing power of the scrip in relation to that of other systems.
  In short, this is a model of a nonprofit administered system - a closed nonprofit administered system - not an open market capitalist system. Like all such systems, it is totally rigid - lacking the flexibility inherent in open capitalist market systems. It lacks the benefits of profit incentives. Purchasing power is administered instead of flexibly increasing or contracting in response to the forces of supply and demand. The model is thus totally invalid for the purposes for which it is introduced by Krugman.

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Copyright 2004 Dan Blatt