Customer Reviews

The Return of Depression Economics

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This book is interesting, worth reading, in part because of it's attempt to avoid moralizing and to find instead `mechanical' reasons for economic slumps, and also for its presentation of facts about sequences of events. The book is also short: the presentation and arguments are concise and easy to follow. The mechanics emphasized by Krugman are large (often leveraged) money transfers and leveraged credit. The examples discussed are about Japan, Thailand, Mexico, Russia, and Brazil. Money transfers via hedge funds are nicely discussed.

Japan, seen from a western economist's eyes, presents a problem economy: stable currency and employment (no growth), and high savings (people tend to keep their money in the bank). Krugman labels this no-growth/high liquidity state a `liquidity trap'. He describes a toy economy that provides a model of a liquidity trap, the Washington DC Baby-sitters' Co-op (see also Akerlof's `Market for Lemons', which came earlier). In the baby-sitter's co-op people start with small, equal amounts of script and a state is reached where parents want baby-sitters (demand) and other parents want to baby-sit (supply) but there is no matching of demand to supply because the script supply (money supply) is too small (savings are too high). Krugman's proposed solution to the liquidity trap is to inflate the script supply. That is also his proposed solution for destabilizing Japan's economy and society: to make saving less desirable by inflating the money supply, therefore inducing people to consume and speculate. The interesting thing is that on Thursday, 14 October 1999, that is exactly what the Bank of Japan agreed to do by announcing that they are buying back bonds. So, we now have running an uncontrolled experiment of Krugman's proposal.

Krugman presents elsewhere a mathematical model of the liquidity trap (see his web page), but it's based on the mythology of a utility function and is only a static model with no dynamics and no time scales. Unfortunately, there is really no correct existing theory of liquidity traps, because `utility maximization' is not an equilibrium condition and does not predict anything measurable real data. As for Japan, one might ask: why label their society as a "problem" just because the economy and currency are stable, especially since people save a lot and there is as yet no large-scale unemployment? The reasons that they tend to save rather than speculate by buying stocks and bonds are several-fold: (1) the mafioso nature of Japan's finance system, where people got burned very badly in the last bubble (see Devil Take the Hindmost, by Edward Chancellor), (2) high financial friction, or large brokerage fees (soon to be destroyed by the introduction of discount brokerage houses into Japan as of 1 October 1999), and (3) the fact that Japan has no social security system. If we ask why western politicians and economists persistently label Japanese habits as `problematic', the answer could well be an unquestioning, bordering-on-dogmatic belief in the econo-religion of growth and progress by the accusers. French farmers rebelled with very good reason against European Union demands for `optimization'.

Peter Drucker pointed out in 1983 in The Frontiers of Management that trade in goods and services no longer determines exchange rates, that money transfers/month across international borders are many times the value of exports/imports. This fact, that the size of money transfers dominates everything, plays a key role in Krugman's analysis. He replays for the reader the tape from (Thailand, 1997 and) Brazil (fall, 1998) where, with still non-increasing prices, but at the onset of an economic slump, Brazil's currency came under pressure due to fallout from the collapse of Russia. Brazil tried to devalue slightly and the currency was routed (via hedge funds). Krugman poses the general question why, when a currency (like the Baht or Real) is weak, and the government (either credit-leveraged Thailand or unleveraged-Brazil) tries to devalue slightly, the devaluation tends to turn into a run on the currency. The answer, he asserts, is that this happens because people believe that it will happen, and this belief then makes it happen (via hedge funds). In other words, a self-fulfilling expectation is created. This rings true because it reminds me of Feynman's observation (in Surely You're Joking, Mr. Feynman) that socio-economic phenomena are not like physics or mathematical laws of nature. In the latter belief doesn't count (you can't make it rain by wishing, and a billiard ball can't think and change its path), whereas in the social arena you can act on beliefs and then cause things to happen.

Summarizing, in comparison with Krugman's book The Self-Organizing Economy, where he seems only to parrot ideas that he didn't invent and doesn't understand (I got this impression in the early pages and so did not read further), I found The Return of Depression Economics to be both enjoyable and informative.

From the July/August 1999 issue of FOREIGN AFFAIRS: A sober -- and sobering -- appraisal of the past two years of financial history. The book covers the unstable dynamics of financial crises, highly leveraged hedge funds, Japan's deflation and liquidity trap, and other economic pathologies. Krugman argues that deficient demand, which has not appeared on such a global scale since the 1930s, is again a potential problem. When appropriate, countries should pursue an expansionary monetary and fiscal policy -- to revive the "Keynesian compact," whereby they maintain free markets but provide government-assured adequate aggregate demand. Krugman also usefully reminds us that economics is a set of analytical tools applicable to diverse situations, not a rigid set of universal principles. He concludes that the Japanese government should generate inflationary expectations so that the real interest rate can decline further -- an unorthodox conclusion carefully derived from straightforward economic analysis. He tells his story in clear prose, without the diagrams economists love. Masterful at presenting complex ideas in simple and sometimes whimsical parables and analogies, Krugman makes serious analysis fun to read.

The beginning of the previous decade saw the establishment of a new doctrine - and almost unbounded optimism about its power: triumph of markets over states, new role of IMF as a policemen of the world economy, "Washington Consensus" about the strict rules that "emerging market" countries are supposed to follow. Later, in the second half of the decade a new impetus was added - rapid development of the Internet and new telecommunication technologies. The olden stuff of economic theories - business cycle, limits of non-inflationary growth - seemed quaint and irrelevant. Isn't today's economy all about "faster, not bigger", bits, not atoms, megabytes per second, not megatons? Not so fast, argued Paul Krugman in this book. It turns out that problems and issues relegated to the history museum have a knack of coming back with a vengeance.

"The Return of The Depression Economics" doesn't mean that the whole world is about to experience the equivalent of the global "Great Depression" of 1930's. Rather, that many countries are now facing problems similar to big issues that occupied economists and policy-makers in the wake of the great shock of world economy in 1930's. At the core of these problems is a massive and long-term demand failure that some economies experience in the aftermath of previous booms. Unlike a recession - a temporary downturn which can be cured by lowering interest rates (injecting money into financial markets), a depression is a state of the economy so out of balance and with destroyed credibility of the financial system, that extra central banks money or fiscal programs is not transferred into productive investments, but stashed away into savings (or leave the country), which further decreases consumption and reinforces downward cycle.

"Depression economics" - a classical Keynesian approach originated from the Great Depressions - deals with problems that are usually tackled by "demand-side" recipes. Its own failures since then led to the emergence of the "supply-side" economics in the late '70-early `80s. It concentrated on unclogging the production side of the market equilibrium - such as cutting taxes, deregulation and privatization. Solid economic foundations of such policies were somewhat lacking (Krugman even dismissively calls them "crank theories"), but it did help solving some problems that plagued western economies in previous decades.

This set of recipes, however, created its own problems. In case of "emerging markets" these prescriptions are incorporated in IMF and "Washington Consensus" orthodoxy. Although seemingly unrelated, they had much in common with "supply-side" ideology. They include restrictive anti-inflationary monetary policy, privatization, deregulation, opening to foreign markets and generally reducing role of the state. At first they seemed to be successful. In particular they led to dramatic reduction of inflation, endemic in the many developing countries. But that, as it increasingly turns out, was an easy part. The crises of the last several years, which P. Krugman describes in details, occurred precisely in those countries that accepted IMF polices. Like with any orthodoxy, the assertion that the causes of these crises are that these countries didn't adhere to them strictly enough doesn't have much merit - the real world never fully conforms to theories.

Many states in fact repeated the boom-bust cycle along the similar lines. At first a monetary "shock therapy" succeeds in stamping inflation - for good, it seems. Domestic and foreign capital flows into privatization projects, government and corporate bonds, attracted by high interest rates prescribed by IMF policies. But country's immature financial system is unable to fully digest the influx of money. This leads to rapid overheating of comprador parts of the economy - nascent stock markets and real estate prices in the nation's capital. Inflation is re-ignited, though to a lesser degree. As the exchange rate is kept steady, soon the country's currency becomes overvalued, and a big trade deficit develops because of uncompetitiveness of the country exports. At the same time local demand stagnates (except the parts directly connected to foreign capital inflow), much of the country plunges into severe depression. At first this usually doesn't concern visiting IMF officials and foreign consultants, seeing new 5-star hotels and Mercedes dealerships. But then markets begin to smell trouble. Triggered by some crisis, interest rates suddenly shoot up and capital stampedes out, forcing the government to spend even more of its budget to pay debts and defend its currency. IMF may come up with a bailout package, but it represents only a temporary solution, solving none of the fundamental problems. Sometimes the crisis abates, leaving a country with bigger debt and more precarious long-term conditions; sometimes it can culminate in a huge storm, like 1997-98 crises that swept many "emerging markets".

These storms that Krugman describes in his book are the crises of globalization, brought about by extreme liquidity and instability of the world financial system. Consider an irrigation system consisting of many reservoirs of various sizes and shapes, connected by a network of pipes and channels. One day a big name engineering consultant appears and prescribes full opening of all sluices and floodgates for more efficient water circulation. At first glance this has only advantages. But when things turn bad (as they inevitably do once in a while) it can affect smaller parts much worse than if they were more shielded from the rest of the system. Big tides and storms mean only fluctuations for larger pools, but can completely drain little reservoirs and devastate weaker areas.

It is no surprise that today one of the most precarious financial conditions exist in Argentine - a country that was the poster child of the IMF programs and "Washington Consensus" philosophy. This philosophy seems stuck in ideas of 10 or more years ago, with very little accommodation of new experience. It is failing now and succumbing to problems already encountered long ago - but where new solutions are called for.

This is clearly one of the best economics books I have read in recent years. Krugman is not only a brilliant economist, but a wonderful writer. He presents a very interesting insight into the recent Asian and Latin American crises and challenges (in a very intelligent and convincing manner) the prevailing economic ideologies shared by most western governments and multinational agencies (e.g.: IMF). This book was a true pleasure to read. Love or hate him, Krugman will make you think.

Despite the simple models taught in Econ 101, our real economic system is extremely complex and intertwined, with a multitude of players of diverse self-interests. It is no surprise then that sometimes this system does not deliver what it promises--better material condition for everyone. System failures in large scale--from currency crisis in emerging markets to stagnation of the huge Japanese economy--are explained in plain English in this book.

Krugman has the great ability in using simple parables and models to help readers (and I suspect, he himself too) understand complex situations. Japan's troubles can be understood when we think about the vastly simpler economy of Baby's coop (which members exchange baby-sittings using coupons), for example. Any model is an abstraction and inaccurate representation of the reality. The key to successful modeling is to use the model that captures the salient features of reality which we most concern with. And that's what Krugman excels at.

In this book, Krugman does deliver his points that the problems facing Japan, Asian countries with emerging economies, and Brazil can be greatly mitigated with the right monetary policy. My complaint is that he virtually ignores other developmental issues facing many developing economies--education, healthcare, and governance. It's true that those are not the points of this book, but helping the reader step back and get a glimpse of these complex facets of the world will certainly make the book a more accurate representation of reality.

Overall, a good and eye-opening read. It gives you a nice description of "one" aspect of the complex socio-economic landscape that affects our lives.

Economic scholar Paul R. Krugman investigates the forces that drive economic growth and recession, and makes sense of several complicated issues. His ability to maintain the essence of a topic while simplifying complex economics with examples and analogies is a hallmark of his work. Despite the gloomy title, the book is not depressing because, Krugman concludes, another Great Depression is not looming in our future. Capitalism has, overall, provided the foundation for prosperity in advanced and developing economies alike. Indeed, the information age has introduced entrepreneurs who have generated wealth while becoming romantic heroes for succeeding in spite of giant corporations. However, Krugman stays alert for dark forces, warning us against panic attacks in the international financial markets, where multiplying negative feedback can overwhelm the effects of monetary policy. We from getAbstract recommend Krugman's in-depth analysis to anyone with an interest in world economics and financial markets.

The 1990s, if you remember the second half of that heady decade, was when many economies went haywire. For a while, Mexico was the talk of the town (if that town included economists) with its currency crisis and resulting debt crisis. Mexico soon gave way to Asia: Korea, Hong Kong, Malaysia, and Indonesia were severely hit. This was all in the context of Japan in recession since the beginning of the decade and experiencing, of all things, deflation and negative real interest rates. And let's not forget Russia's devaluation and Brazil's economic woes.

The average American (and perhaps European) can be forgiven for yawning over such arcane topics as hedge funds, supply-side economics, and debt rescheduling. But that is no excuse to ignore Paul Krugman's Return of Depression Economics, an engaging primer on how these economies went south and what governments can do to prevent similar disasters. Krugman has always been, even before he went off the deep end in his column for the New York Times, controversial. Vocal and egotistical, he has made a number of enemies in his brilliant career as one of the world's foremost economists. He undoubtedly recruited a few more members to the Krugman anti-fan club with the publication of the Return of Depression Economics, where he calls supply-side economics a "set of silly ideas" and "a crank doctrine". He argues that an orthodox free-market, laissez-faire ideology has clouded many economists' thinking, leading policy-makers to implement unsound policies that prolong developing countries' - and Japan's - recessions.

But forget Krugman's thesis. His argument that Keynesian economics still has a place in today's world is less fascinating than his history of the crises in Latin America and Asia. Krugman does his best to avoid jargon and present the subject to the layperson, writing in a casual, colloquial style. Using the "Capitol Hill Babysitting Co-op" as a model, he easily explains what happens to economies when demand decreases and what the central government can do to stimulate this demand. He walks the reader through how a lack of investor confidence can turn into a self-fulfilling prophecy and leave economies in a shambles. And, of course, being Krugman, he takes every opportunity to point out when he was right in the past and others were wrong.

Anyone who wants to understand international macroeconomics must read this book. The intuition is superb and the case study approach makes it an exciting read. However, to better appreciate the brilliance of the book, I recommend reading "World Trade and Payments" by Caves, Frankel and Jones. The exposition of the Mundell-Fleming model under various exchange rate regimes and capital control regimes in that book are excellent. Paul Krugman's book reinforces those concepts with case studies.

Krugman's book was one I terribly enjoyed. Having had to read it for my International Economics class I found it fascinating and it really opened my eyes to some of the shocking realities around me. Having grown up in the 90's when the economy was chugging along, I never expected it to stop. I grew up in a microcosm of excess. Never would I wince at dropping $80 for a pair a jeans I had in several other finishes. I attended a pretigious university at the tune of $30,000 per year without hesitation, thinking the drop in the economy was surely short term and I would be in no tough spot to find a high paying job upon my graduation. Now I have begun to understand that may not be the case, and the economy really never was as great as everyone thought. I think this book is an excellent piece for my generation to examine.

Let me start by quoting from one of Prof. Paul Krugman's articles: "Japan, we are told, cannot have an economic recovery unless it carries out massive structural reform. Where did that come from? Structural reform is supposed to help the supply side of the economy, not be a precondition for increasing demand. Southeast Asia, we are told, cannot have a recovery unless it carries out a complex process of restructuring internal debt. Maybe, but that's a new principle - made even more dubious by the fact that the massive overhang of bad debt is at least as much a consequence as a cause of the region's slump. Brazil, we are informed, must suffer a recession because of its unresolved budget deficit. Huh? Since when does a budget deficit require a recession (which itself will, of course, make the deficit that much harder to bring down)?"

Why do some economists and policymakers refuse to acknowledge the apparent increase in the scarcity of demand that has become more and more conspicuous in the last years? After all, it was those logical counter-cyclical measures (that is, Keynesian-style remedies) that helped the advanced nations smooth out recessions. Why then, do pundits insist on the emerging economies' adopting perverse pro-cyclical measures during slowdowns (namely, increasing interest rates and reducing public spending), which clearly only aggravate those countries' travails? Well, there is one explanation, according to Prof. Krugman: "fear of speculators". Unfortunately, developing countries do not enjoy the same level of credibility as the developed economies. If an emerging economy displays some sort of imbalance (and most of them undoubtedly do, whether it is excessive debt, "cronyism", or, as often is the case with countries that peg their exchange rate, an overvalued currency), then it is very likely that investors will not trust that country to take the appropriate measures and get back on the right track. Fearing the development of an economic crisis, those investors, through their disruptive crowding-out, will actually trigger the crisis. In other words, panic becomes self-justified, and the crisis becomes self-fulfilling. After all, we live in Keynes' world, where fundamentals don't matter that much when an investor makes his decision according to the decisions he thinks the other investors are about to make (this is sometimes called a non-ergodic environment).

Prof. Krugman notes that such prejudices towards the developing countries are very unfair, especially if those economies are, at least on the whole, safe and sound. In his words: "sometimes bad things happen to good economies". While in the long run structural imbalances must be addressed (after all, don't even the developed economies suffer from them - for instance the high rate of unemployment in Europe, sometimes dubbed "Eurosclerosis"?), and while developing economies carry their own part of the blame, in the short run one cannot disregard the most fundamental demand-side economics principles, and inflict further pain on an ailing economy for the sake of some free-market ideal. To quote Prof. Krugman once again: in a world where there is often not enough demand to go around, the case for free markets is a hard case to make".

The views expressed in this book certainly sounded heretical at the time of writing. Today, well, they may have become more or less mainstream, but public policy still has a long way to go - notice, for instance, the incapability of the Bank of Japan to actually create inflationary expectations (notwithstanding the fact that, at least in principle, it is - finally! - committed to doing so). In other words, Prof. Krugman still has a strong and pertinent point, maybe even more than he did two years ago, especially since the United States appears to be on the brink of recession. As for Lord Keynes' remedies, well, if the US manages to avoid recession - and it just might, given Mr. Greenspan's strong commitment to cutting interest rates by no matter how much is necessary - they will (as usual) be vindicated.