An inflated sense of depression The Return of Depression Economics, by Paul Krugman, WW Norton & Co, 1999, 176 pages

from NewsLink, Vol. 4, No. 2, Winter 2000

"Never trust an aircraft designer who refuses to play with model airplanes,” writes Paul Krugman early in The Return of Depression Economics. "And never trust an economic pundit who refuses to play with model economies.” In this latest work, Krugman of MIT employs a model about a babysitting cooperative in Washington, D.C. to illustrate Japan's predicament.

In the 1970s, a group of professionals needed babysitting services. They formed a cooperative whereby each couple would be issued coupons for each hour of service provided. But soon couples began hoarding their coupons, rather than going out. A recession hit the co-op as couples spent too little time out and too much time accumulating coupons. This created a “lack of effective demand.”

For almost a decade, Japan has been mired in a “growth recession,” described by Krugman as a state in which an economy grows but not enough to make use of its capacity. Despite trying to regain its vigor through fiscal policy, modest tax cuts and excessive public spending, Japan's wheels aren't moving much, even as the rest of Asia is pulling out of its recession.

Explanations placing the blame on Japan's “crony capitalist” system are insufficient, says Krugman. No one complained about “crony capitalism” a decade ago when the highly interlocking cooperative model of keiretsu (or shall we say successful crony capitalism) captivated the best minds of business journalism.

Fiddling with a baby co-op model is Krugman's way of finding a solution. One solution would have been to print more coupons. Similarly, says Krugman, Japan should pursue the “inflation heresy” by letting the printing presses roll.

Japan, says Krugman, is in a “liquidity trap” in which interest rates are already so low that there is no realistic chance of their falling any lower. A natural remedy of moderate inflation “may be necessary if monetary policy is to be able to fight recessions.”

Krugman seems to forget that the “liquidity trap” is a device invented by his ideological forbears in order to argue against relying on monetary expansion to “fight recessions.” If Krugman is going to stir up Keynesian ashes as a way of lighting a fire under Japan's economy, then he should at least get his ideology straight.

In fact, the Japanese need look no further than the United States for what seems to be the right policy mix for economic growth, which is to say relatively low taxes combined with a monetary policy aimed at preventing, rather than bringing about inflation.

The statistics detailing the American miracle – rising productivity, low inflation, low unemployment, lower poverty, increased incomes – are so impressive that Americans see nothing but sunshine. Krugman thinks we ought to pay more attention to the clouds over Japan and Asia and warns us – as do most economists – that we are far from repealing the business cycle.

What worries Krugman is the fact that “over the last two years seven economies – economies that still produce about a quarter of the world's output and that are home to two thirds of a billion people – have experienced an economic slump that bears an eerie resemblance to the Great Depression."

He writes, “The kind of trouble that the world has recently suffered is precisely the sort of thing we though we had learned to prevent” after the Great Depression.

For Krugman the chief culprit appears to be laissez faire policies. Purging the poison out of the system, letting currencies float and letting the market work itself out are among the “obsolete doctrines” Krugman has made a career of decrying.

Given his fascination with Keynesian remedies that have not been taken seriously for the last 40 years or so, it would seem that Krugman has some pondering to do. And when it comes to “supply-side” economics, Krugman is equally wedded to now-dead prejudices. Time and again he calls supply-side economics “a specific set of silly ideas.”

Perhaps the problem lies not with the supply-siders (who are really just micro-oriented macro economists) but with Krugman's unwillingness or inability to come to grips with tax policy. Doing so would force him to face up to the possibility that ever-rising marginal tax rates inevitably shrink economic activity, and with it, tax revenues.

But his book is more about Asia than macroeconomics. So let's be clear: Japan's malaise cannot be cured by any policy of easy money. The roots go deeper. Krugman is wrong when he dismisses as hindsight arguments that link Japan's problems to its crony-capitalist way of doing business.

Students of Japan long ago raised doubts about Japanese industrial policy and protectionism. Explanations rooted in “sociology” and dismissed by Krugman go to the heart of Japan's problems.

Yes, Japan is a dynamic, high-tech, export-driven economy with a highly educated and productive workforce. But the success Japan demonstrated producing automobiles, steel and electronics has been difficult to replicate in the New Economy. For reasons rooted in its business culture and not any liquidity trap, Japan has been remarkably slow to embrace the Internet and remains distrustful of immigration and open markets.

Does Krugman the economist owe anything to Krugman the journalist? Throwing the term “depression economics” is not the stuff of responsible economics or journalism. Perhaps the draw of economic potboilers for idle business travelers in airport bookstores motivates this kind of alarmism. Perhaps there will always be economists ready to prop up Keynes for yet another reincarnation. But yelling “depression” in a crowded global marketplace requires a better defense than Krugman offers here.

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