Book Reviews
The Return of Depression
Economics and the Crisis of 2008, by Princeton Economist, NYT columnist,
and Nobel Laureate Paul Krugman.
Review by Terri Zavada, managing partner, Zavada International, Inc., a boutique
consulting firm specializing in advising clients on successful negotiating
strategies for use in overseas government policy disputes.
Even the greatest minds in economics thought we had this one solved. Paul Krugman begins his most recent book with a 2003 quote by Robert Lucas, winner of the 1995 Nobel Memorial Prize in Economics, before the American Economics Association: the "central problem of depression-prevention has been solved, for all practical purposes." Even Ben Bernanke, Krugman notes, as recently as 2004 in his then capacity as Federal Reserve Board Member, gave a speech arguing that modern macroeconomic policy had reduced the problem of the business cycle to the point that it was more a nuisance than a front-burner issue.
On the surface, it was true. The world had enjoyed roughly 70 years of relatively worry-free economic growth, led by the efforts of central bankers (especially the Fed) to control monetary policy and supplemented by a fiscal push or pull as necessary. It became unfashionable for economists to focus on the lessons of 1930s-style depression economics and mechanisms for controlling the business cycle. Moving on to new concerns, such as the role of technology and globalization in the new economy and the importance of sustaining long term growth, Krugman argues that the profession failed to recognize and address important weaknesses capable of wreaking worldwide economic havoc.
Krugman presents a compelling thesis that, in retrospect, warning signs were abundant that the business cycle had not been tamed, that we did not understand the economy as well as we thought we did, and that the world remained susceptible, indeed increasingly vulnerable, to self-fulfilling financial panics. In the lucid and engaging style of Krugman the New York Times columnist (no worries - this is not an academic treatise in the style of Krugman the brilliant econometrician), this book offers a history of regional crises and financial and regulatory missteps leading to today's financial and economic collapse. Krugman argues that there were signs aplenty of a return to the possibility of depression economics and offers a compelling reflection on how economists and governments got so many things wrong.
Krugman begins his reflection with a brief review of the Latin American economic crises of the 1980s and 1990s. Most interesting is the discussion of the December 1994 Tequila crisis, which concluded what Krugman describes as a period of foreign business euphoria over prospects for the Mexican economy. In a surprising and botched move, the Mexican government devalued its currency, leading to a collapse of confidence not just in Mexico but beyond, even in countries like Argentina which at the time was enjoying fundamentally strong economic performance. Ultimately, the World Bank moved in to rescue Argentina and the U.S. Treasury offered a line of credit to Mexico. Investors returned and, although businesses and workers had been devastated, the path to recovery was laid.
Krugman's take on the Tequila crisis is that policymakers learned the wrong lesson. They falsely concluded that the factors leading to the crisis were uniquely Mexican, that lessons from the episode held little relevance to the rest of the world, and that the IMF and the U.S. Treasury Department had the situation under control. While their interventions were able to stem the crisis, policymakers failed to recognize the larger problem that seemingly successful economies were not immune from financial crisis. Ultimately, governments were unprepared for a Tequila-style crisis in Asia a few years later, or the fact that the policies that worked in Mexico and Argentina would not would be effective in either Asia or the global crisis that erupted in 2007.
While the Latin American experience provided an early warning that financial panic could still be a problem in today's economy, Krugman looks to the Japanese experience of the 1990s as a guide to the handling of speculative bubbles asks why U.S. policymakers did not recognize the relevance of Japan's example to its own case before the housing bubble burst here. Krugman's Monday morning quarterbacking is both interesting and relevant as it draws the reader's attention to the problem of the "liquidity trap" (that point at which monetary policy ceases to be effective at encouraging spending) and the practical limits to a government's ability to use fiscal policy to stimulate growth. Conventional economics offers very few options for governments that find themselves in this situation. Indeed, Japan failed for a decade to find the correct mix of monetary and fiscal policy to kick-start growth in its economy. (Here, Krugman throws out the provocative suggestion that policymakers in such situations should unhitch themselves from conventional wisdom and try stimulating a bit of inflation.)
Krugman's lively review of the Asian financial crisis hooks back into many of his conclusions with regard to the earlier Latin American crisis. Specifically, he emphasizes the relevant questions: Why should the actions of one small economy (in this case, Thailand) lead to regional economic meltdown? Why didn't, or why couldn't, governments prevent catastrophe, and what happened to macroeconomic policy?
His answer, relevant to Mexico in 1994, to Asia in 1997, and to the global economic crisis today, is panic. Krugman provides the reader with a wealth of information on events leading up to and in response to the Asian panic and goes on to explain the powerful feedback loop that exists between confidence, the financial markets, and the real economy. The surprise in 1997, he concludes, was not so much that the feedback loop existed. The surprise was that, in an era in which economists thought macroeconomic policy had all but resolved problems associated with the business cycle, the feedback loop could still be so devastating.
Krugman then considers the perverse economic policies prescribed by international rescue teams for countries caught up in contagion-induced panic. When Keynes would have ordered up low interest rates to spur investment and fiscal stimulus to spur job and wage growth, why did the IMF insist on austerity? What, he rightly asks, happened to macroeconomics? Here, he discusses the role of economist as amateur psychologist. Because they believed they had to play the confidence game, rescuers' moves were meant to calm skittish markets and, in the end, had very little to do with economics. Krugman reviews the kinds of choices and dilemmas facing governments in financial crisis and answers the question, was the confidence game the correct response to panic, or did IMF policies make the situation worse. Disappointingly, particularly in light of the current global crisis, he concludes that the IMF did not play the role of villain. There were simply no good choices to be had.
This is not to say there are no villains in Krugman's story. Having reviewed the major crises, he moves into an enlightening, almost entertaining (if only it weren't so sad!), discussion of the world's misplaced confidence in deregulation. Alan Greenspan, George Bush, and hedge funds and their ilk all take their hits here. For those wishing to deepen their understanding of how pretty much unregulated and misunderstood financial instruments came to dominate and ultimately undermine the American banking system, this section makes fine reading. Krugman again does an excellent job of Monday morning quarterbacking. How, he asks, did government fail to recognize the economy's vulnerability to the unregulated segment of the banking system, particularly when it was just such vulnerability that made the Great Depression possible? Where were the regulators? Where was the safety net?
In his book, Krugman beautifully
presents the history of the mess we find ourselves in today. The only real
disappointment is that even the author, a man talented enough to win the Nobel
Prize in Economics, can't provide us with a silver bullet, a quicker, easier
or better way out. He certainly highlights that the central question of depression
economics - how to stimulate enough demand to make use of the economy's capacity
- is back. He also offers the rather obvious solution that we need to get
credit flowing again and prop up spending. He is supportive of current financial
rescue efforts and argues that more and more innovative attempts will be needed.
He advocates for a strong fiscal stimulus. But even he recognizes that we
need new ideas. What he really advocates for is a willingness to toss aside
old and ineffective doctrine and an openness to try new policies. Let's hope
it works.
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