No need for a depression

The Return of Depression Economics
August 6, 1999

Keynesian policies have had their day, says Meghnad Desai.

John Maynard Keynes won his battle against the classical orthodoxies of his day because of the Great Depression. When the upturn came, during the war, the way was prepared through national income accounting and budget preparation for the use of Keynes's theory in peacetime. It was a great triumph for the dismal science that for a quarter of a century postwar, Keynesian recipes worked and the prospect of depression receded. Recessions became milder and the business cycle was once again thought to have been eliminated.

But the prosperity generated by Keynesian policies sowed the seeds of their destruction. In the 1970s, Keynesians lost to monetarists, their arch enemies. At the same time, there was a second assault on Keynesianism by the Chicago school, a liberal attack that also undermined one of its pillars: the need for control of international capital movements. Thus began the escape of capital from its national fetters, while labour remained grounded in national territorial politics. Economists still used effective demand-and-supply notions, but their content was distinctly classical rather than Keynesian. "New classical" economics became the norm, with its belief in rational expectations, denial of involuntary unemployment and emphasis on monetary discipline.

At the Massachusetts Institute of Technology the economists never quite believed in the hard Chicago version; they accepted that in the long run Chicago was right and involuntary unemployment could not persist, but they craved some short-run evasion of the juggernaut of the "natural rate of unemployment". And so there arose the distinction between "salt water" (MIT/Harvard) and "sweet water" (Chicago) macro-economics.

Paul Krugman is a salt-water type and one of the best. He has done pioneering work with Elhanan Helpmann on international trade theory, innovated in the theory of dynamics of foreign exchange markets, and invented a new field, the geography of economics. He is also a prolific populariser, refuting the claim made by many that modern economists are narrow, technical nerds. His new book is a readable, racy account of the economic turbulence of the past five years, centred on the Asian crisis of 1997, which became a global problem during the summer of 1998. Along the way, Krugman takes in the story of the Mexican peso collapse of December 1994, the Brazilian crisis of 1998 onwards, the Japanese stagnation of the past five years and the hedge-fund debacle of last summer.

His message is that in the revival of classical economics over the past 25 years and the pursuit of fiscal and monetary orthodoxy, especially by the International Monetary Fund, a vital lesson of Keynes's work has been missed. The "new classical" policy-makers do not admit that lack of demand could be a problem, and their insistence on cutting the budget deficit and depreciating the exchange rate - often after having foolishly tried to defend it by raising interest rates - makes a crisis worse. Defying current orthodoxy, Krugman argues that capital controls may be helpful, that devaluation could be helpful for developing countries in trouble and that a depression on a world scale is quite likely. In other words, we may yet be reconverted to Keynesian economics.

Non-economists of a serious bent will enjoy this book. Economists should also read it because often even macro-economists do not bother to know the real world they are modelling mathematically. And yet I have to say I disagree with a lot of it. Given the brilliance of Krugman's serious work, this book is a lazy effort, a quick fix. Here Krugman does not get into any deep arguments; he prefers simple stories. But as often happens, such stories are significantly misleading.

Take Krugman's babysitting club, in which parents babysit for each other and exchange tokens, earning tokens by acting as babysitters and spending them by having others babysit their children. Such a system can run into the problem that some people have tokens they cannot spend or do not want to spend, but prefer to save for a rainy day (or a summer's evening). Now how do those who are short of tokens earn them if there is no demand for their babysitting services? According to Krugman, this story illustrates shortage of effective demand and he suggests that the solution is for the committee of the babysitting club to issue extra tokens. You see, these tokens are money and in a depression you print money. Geddit?

Well, not quite. What you have here is a barter system with fixed prices. You could make the prices flexible, ie devalue the tokens. You could even extend the barter beyond the single good and allow cash payments (capital imports) for those who want their babies sat but do not have tokens. Issuing new tokens is a subtle way of devaluing existing tokens, ie using inflation to cut real wages and increase employment. But this was precisely why Keynesian policies did not work in the 1970s, and the monetarists were able to show that pumping money at some stage only causes inflation without reducing unemployment.

Keynes knew that the success of his policies depended on capital movements being restricted and governments controlling their money supply by selling debt to a captive market of domestic savers. But if savers are free to save abroad and if businessmen can invest abroad, you need a new way of thinking about national economies. Krugman is clever enough to be able to do that, but instead he has fallen back on the simplicities of an outdated macro-economics that he would not teach his graduate students at MIT.

Even the IMF has not grasped the logic of macro-economics in a globalised world. This is why its policies were inappropriate in Asia. The problem was private bank lending, and the IMF came down hard on public spending, which was not at fault. But the IMF is wedded to sweet-water macro-economics, which is as obsolete as the salt-water variety. Krugman ridiculed globalisation when it became fashionable five years ago by calling it globaloney. Nice slogan, yet it is because of greater capital mobility that the world economy is back to a globalised phase that was last seen before the first world war.

There are in fact no crises, only business cycles. Mexico bounced back 18 months after the peso crisis, and now we see that South Korea is bouncing back, as are Thailand and Malaysia. Even the Indonesian rupiah has recouped half its depreciation. Brazil, which was on the brink of a "crisis" in January 1999, is now out of the crisis. There may be a run on the Argentine currency or the Moldovan one. But why make a fuss?

The triumph of Keynesian economics had lulled economists into forgetting that capitalism is a cyclical process and also that there are always overshooting, bad investments and credit crunches. The illusion of control over the macro-economy lasted a while, but now we have to mitigate turbulence rather than seek optimal control. This is where the current situation is much more Marxian or even Hayekian than Keynesian. It is not so much a matter of pumping in extra money but of getting the prices right.

Nowhere is this better illustrated than in Japan. Its economy grew sluggishly for many years and last year went into recession. Its industry is protected from competition at home and driven to export abroad by domestic over-saving and under-consumption. Faced by globalisation, this structure is untenable. Many spending packages have been launched by the government, and the money supply has been pumped up until the interest rate is zero. Krugman argues that Japan is in a liquidity trap and needs inflation plus more devaluation. But a liquidity trap is when interest rates stay positive and cannot be pushed low enough for new investment to generate full employment - yet if nominal rates are zero and inflation is also practically zero, how can that be a liquidity trap? In fact, savings are still too high and investment too low; and low interest rates are the problem, not the solution.

The cause is that many elderly Japanese live off the interest from their savings. As interest rates fall so does their income, and out of fear they cut their spending and save more. Bad investments in recent times have saddled many Japanese banks with bad debts and they have refused to loan money to business. But of late, banks have been restructured and money is flowing back; the economy is beginning to revive and falling bond prices are encouraging the elderly to spend. Devaluation, recommended by Krugman, would only increase Japan's trade surplus and punish consumers by keeping import prices high.

Thus the problem of the late 1990s and the coming decades may not be a lack of effective demand so much as that exchange rates and interest rates have to be so managed that a country can take advantage of the large global market that exists for its goods. There can be no lack of demand in an open economy; only its exchange rate can be too high or its prices uncompetitive. There will be cycles no doubt, so-called crises. But they will be the staple of the globalised economy. This does not mean a depression, as Keynesians hope and pray because that is the only scenario in which Keynesian policies for a closed economy can be revived. Keynes has had his day; what we need is some new economics - and who better to provide it than Krugman, if only he would stop writing bestsellers and get serious?

Lord Desai is director, Centre for Global Governance, London School of Economics.

The Return of Depression Economics

Author - Paul Krugman
ISBN - 0 713 99389 8
Publisher - Penguin
Price - £16.99
Pages - 176

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