Depressing Economics

January 19, 2009 • Commentary
This article appeared in Forbes on January 19, 2009

With the help of a Nobel Prize and global recession, New York Times columnist Paul Krugman has refurbished his 1999 book The Return of Depression Economics to suggest he was “right to be worried”–though a decade premature. The bulk of the book, however, retitled The Return of Depression Economics And The Crisis of 2008, still deals with foreign currency crises from 1995-’98. What could that possibly have to do with recent global events?

“The world is lurching from crisis to crisis,” explains Krugman, “all of them crucially involving the problem of generating sufficient demand. Japan from the early 1990s onward, Mexico in 1995, Thailand, Malaysia, Indonesia and Korea in 1997, Argentina in 2002, and just about everyone in 2008. … Once again, the question of how to create enough demand to make use of the economy’s capacity has become crucial. Depression economics is back.”

Did all those crises really demonstrate insufficient demand? Krugman quarrels with economists who thought “the trade deficits of Thailand, Malaysia and Indonesia were a sign … of economic strength.” But soaring imports and prices (inflation hit 75% in Indonesia) certainly were not a sign of weak demand.

A new introduction says, “In the late 1990s a group of Asian economies…experienced an economic slump that bore an eerie resemblance to the Great Depression…I saw it as a troubling omen for all of us.” Unlike the Great Depression, the Asian slumps were brief. Real GDP in Korea fell 6.9% in 1998 but rose 9.5% in 1999 and 8.5% in 2000. The Thai economy grew by 5% a year from 1999 to 2007. Mexico’s economy grew by 5.5% a year for five years after the 1995 peso meltdown. Krugman is right that such troubled economies often suffered terrible advice from the International Monetary Fund, as I too have long argued. Yet they bounced back anyway.

Any pretense about Thai or Mexican currency problems of the 1990s providing instructive “omens” for today’s U.S. is plain drivel. The book’s new material, however, finds another omen in “an effort to explain how the United States found itself looking like Japan a decade earlier.” Unfortunately, even that trendy comparison relies on the original book’s pre‐​1999 statistics. “In 1998,” wrote Krugman, “Japanese industry produced less than it had in 1991.” This, he adds, was “an omen: if it could happen to the Japanese, who was to say that it couldn’t happen to us? And sure enough, it did.”

Updating that data, it turns out that Japan’s index of industrial production was still no higher in 2004 (108.5) than it had been in 1991 (108.4). Over the 16 years from 1991 to 2007, industrial production rose by 43.7% in the U.S., but by only 8.4% in Japan.

Sure enough, what happened to the Japanese has not happened to us. Strangely enough, Krugman nonetheless proposes that the U.S. emulate Japan’s failed public works schemes.

“By 1996 [Japan] was running a quite nasty deficit of 4.3% of GDP,” he writes; “the attempt to jump‐​start the economy with deficit spending seemed to be reaching its limits.” Yet Japan kept relying on fiscal nostrums, with budget deficits the averaged 6.9% of GDP from 1998 to 2005. Did such massive government borrowing create jobs? On the contrary–there were fewer Japanese jobs in 2007 (64.1 million) than in 1992 (64.4 million).

Krugman thinks the Fed is “presiding over a Japan‐​style liquidity trap.” At a 1998 Keidanren‐​Cato conference, by contrast, I noted that whenever there is great risk of bank failure, “shaky banks naturally want to hold more reserves, and people want to hoard more currency. The central bank has to accommodate those liquidity demands before additional bank reserves and currency can have any ‘reflationary’ effect. If the central bank fails to convert enough securities into cash, through the discount window and open market purchases, then people have to liquidate assets and inventories to get cash. To stop such a deflation, the Bank of Japan merely has to purchases as many domestic or foreign securities as necessary.”

Writing about the U.S. rather than Japan, Ben Bernanke made similar comments about “quantitative easing” in a prophetic May 2004 American Economic Review study, “Conducting Monetary Policy at Very Low Short‐​Term Interest Rates.” Krugman dismisses Bernanke’s quantitative easing because “the monetary base is ‘only’ $800 billion.” Yet the monetary base (bank reserves and currency) doubled from August through December of 2008, approaching $1.7 trillion.

The book’s new comments about the financial crisis are commonplace: “The financial system turned out to be much more vulnerable to the side effects of falling house prices,” says Krugman, and “the consequences when the bubble burst were worse than almost anyone imagined.”

Government regulators were as blindsided as everyone else by the huge leveraged investments in mortgage‐​backed securities, just as they were astonished by Enron and Bernie Madoff. Yet Krugman somehow ties such perennial failure of government regulation to “the ideology of the George W. Bush administration.”

The old parts of this book are outdated and have not aged gracefully. The new sections are mostly humdrum opinion, partisan rancor and shady, cyclical excuses for “sustaining and expanding government spending.”

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