November, 2000, Vol. 123, No. 11
Book reviews
The Return of Depression Economics. By Paul Krugman. New York, New York, W. W. Norton and Company, 1999, 176 pp. $23.95.
This interesting yet very complicated book offers a tour of the major economic crises which have spread across the world in the 1990s, including those of East Asia, Brazil, Mexico, and Russia. Paul Krugman provides pithy accounts of the devaluation of Thailand’s baht currency, the "financial doomsday machine" created by hedge funds, and the "liquidity trap" of the Japanese economy.
This economics professor at the M.I.T. maintains that while the world economy is not and probably will not be in depression in the near future, "depression economics" policies have staged a comeback. Krugman draws analogies between factors behind the economic crises that afflicted East Asia (including South Korea, Thailand, and Indonesia), Brazil, Mexico, and Russia in recent years, and factors behind the Great Depression in this country during the 1930s. He characterizes the Great Depression as a condition created by a collapse in aggregate demand that was prolonged by inaction of the Federal Reserve (Fed) and the Hoover Administration. He points out that the Fed could have ended the Great Depression by dramatically increasing the money supply. The author points out the irony in how the International Monetary Fund (IMF), the last-resort lender to national governments, has apparently not learned from the mistakes of the 1930s. In an effort to satisfy investors, the IMF has traditionally required fiscal and monetary austerity in the countries it lends to. Krugman says this policy of tight national budgets and tight money supplies is folly, reminiscent of economic conditions in this country during the Hoover Administration, conditions which prolonged the Great Depression.
When countries experiencing economic crises desperately need loans from the IMF, they have routinely been required to raise interest rates to extremely high levels (to appeal to creditors), increase taxes, reduce national spending, and wait for the economy to improve. The author points out that the IMF’s recession-fighting policies are the opposite of those of this country during post-World War II recessions. He asserts that IMF requirements for double-digit interest rates and reduced national spending in countries experiencing recessions is ironically a guaranteed strategy for a prolonged, severe recession.
The author proposes that countries whose economies have suffered from investor panic and capital flight should avoid implementing austerity measures of the IMF. Instead, these countries should apply emergency controls on outflows of short-term, liquid capital investments. Moreover, the author recommends that countries tax companies that borrow in foreign currency. Accordingly, countries experiencing a reduction in demand for exports may then be able to allow the value of their currencies to slide, yet avoid provoking a financial collapse.
Devaluing one’s currency is an easy way for a country to reduce the price of its products when faced with a sudden reduction in demand for them. However, collapsing currencies end up bankrupting local businesses and banks who have borrowed in foreign currencies, because the currencies they must repay are much more expensive.
The book analyzes economic crises of selected countries in the 1990s. These include the currency crises of East Asia in 1997 and 1998, the Japanese recession of the 1990s, the Brazilian financial panics of 1998 and 1999, and the collapse of the Mexican peso and other Latin American currencies during 1994 and 1995. The most interesting parts of the book examine the factors behind East Asia’s economic woes, including those of Japan.
Krugman’s main explanation for most of these crises involves the increased proliferation of liquid financial investments made in "emerging markets" from investors abroad. Sudden shifts in international investor sentiments, resulting from irrational, herd mentalities of international investors, have wreaked havoc on emerging markets. For decades governments have removed regulatory restraints on domestic and international trade. International investment fund traders tend to change opinions suddenly, withdrawing liquid, indirect investments from developing markets in a panic.
The main villains in this book are the U.S. "hedge funds," investment institutions that control assets around the world, well in excess of the respective investors’ wealth. Such assets include foreign currencies, stocks, bonds, and real estate. Reputable hedge funds have, in recent years, been able to make investments that are up to 100 times the size of their owners’ investment. Therefore, a relatively small drop in asset prices can result in huge losses for hedge-fund investors and corresponding panic and capital flight. According to Krugman, "the competition among hedge funds to exploit ever narrower profit opportunities had created a sort of financial doomsday machine."
Despite the speculative bubble that developed in East Asia in the late 1990s, the author contends that the region’s growth was real and solid and was not based on just borrowed funds. From the start of the East Asian "economic miracle" until the early 1990s, the economic growth of that area was for the most part financed by a pay-as-you-go basis, with little money borrowed from abroad. The small amount of money that was borrowed was invested mainly as direct foreign investment for building plants for manufacturing exports.
In 1990, private investments made in "emerging markets," including those of South Korea, Thailand, Indonesia, and Mexico, totaled $42 billion. By 1997, private capital flows had ballooned to $256 billion. In the early 1990s, most of the money was invested in Mexico and the rest of Latin America. However, after 1994, an increasing share was invested in the economies of Southeast Asia.
The July 1997 devaluation of Thailand’s "baht" currency set into motion depreciating financial and real estate asset values that spread across much of Asia. From 1996 to the first half of 1997, an increasing number of speculative investments in Thai real estate and stocks, financed by external lenders, deflated in value. Consequently, foreign lenders increasingly stopped lending money to Thailand.
The loss in investor confidence quickly spread from Thailand to Malaysia, Indonesia, South Korea, and Japan. By 1998, all of these countries were experiencing recessions. As far as international investors were concerned, financial losses in one Asian economy were a precursor for more in other Asian economies. However, these economies were only marginally linked, engaging in a relatively small amount of trade with neighboring countries. Increasingly though, lenders avoided lending to these countries, and real estate, stock, and currency values plummeted.
Between 1953 and 1973, the Japanese economy transformed itself like no other in history. The country changed from a mostly agricultural country to the "world’s largest exporter of steel and automobiles." But since 1991, the Japanese economy has languished in a recession. Krugman notes that Japan produced less in 1998 than in 1991. During the 1990s, Japan, to no avail, repeatedly applied the two standard remedies for increasing consumer demand and ending a recession. Its government lowered interest rates and increased government spending.
After its bubble economy burst, Japan eventually lowered interest rates to near 0 percent. But the economy and consumer demand continued to slump. Throughout the 1990s, the Japanese government borrowed money and invested in public works projects, such as roads and bridges, even when many agreed they were not needed. In 1998, Japan projected a deficit equal to 10 percent of its GDP. But the successes of the stimulus policies have been short lived.
Japan is caught in a "liquidity trap," a condition in which the public chooses to hold any amount of money that is supplied. Maybe due to its aging population, or maybe due to fear of its future economy, Japanese consumers have not been willing to increase spending to the point of approaching their economy’s capacity.
Krugman suggests that the answer to Japan’s liquidity trap may be the expectation of inflation. Since 1994, consumer inflation in Japan has remained near 0 percent. For the 12-month period ended April 2000, Japanese consumer prices decreased 0.8 percent. The author suggests that the Japanese government create inflation by drastically increasing the money supply, and convince the public that consumer inflation is here to stay. Perhaps when its citizens expect annual inflation of 3 to 4 percent over many years, and when they expect the purchasing power of their yen will be less next month or next year, they will hoard less yen and increase spending and borrowing.
I recommend this book to readers who understand the fundamental theories of international finance and macroeconomics.
—Todd Wilson
Office of Prices and Living Conditions,
Bureau of Labor Statistics
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